Question

10. Answer both parts (a) and (b) of this question.

1. [9 marks] Explain Keynes’ three conjectures about the consumption function. Describe the evidence that is consistent with these conjectures and the evidence that is inconsistent with them.
2. [16 marks] Compare and contrast the Life Cycle Hypothesis with the Permanent Income Hypothesis. Which of these two hypotheses do you think deals more satisfactorily with the

well known “consumption puzzle”? Explain.

Answer 1

a) Unlike today where economist are largely dependent on computerized statistical modeling techniques to analyze consumption patterns, John Maynard Keynes made three conjectures about the consumption function based on general observations :

1.    0 < MPC <1

Firstly, he conjectured that value of marginal propensity to consume lies between zero and one. This means that when an individual earns an extra dollar of income, he/she spends some of it as well as saves some of it. Thus with a rise in an individual’s earning by an extra unit of any currency (say dollar), his/her consumption as well as savings both increases.

                         MPC ↑ : C ↑ and S ↑

2. APC falls with increasing level of income

Secondly, he conjectured that the ratio of consumption to income falls as income level rises. APC is known Average propensity to consume. According to Keynes, savings was a luxury, so with higher level of incomes the rich were believed to save a higher fraction of income as compared to poor class of the economy. This meant, as income increase average consumption levels of poor rises as compared to rich and they tend to save lesser.

                              ↓ APC = [C / Y ↑]

3. Consumption depends only on Income

Unlike the classical economist, who believed that interest rate were an important determinant consumption, Keynes conjectured that consumption is primarily determined by Income only and interest rates have no role to play in analyzing the consumption levels.

Thus based on the above 3 conjectures, the below consumption function was derived:

C = C(bar) + cY

Where, C = Consumption

C(bar) = Autonomous consumption when income levels are zero

c = Marginal Propensity to consume

Y = Disposable Income {Income after paying taxes}

After the proposal of above consumption function there were many studies done to verify the above conjectures. Some research was consistent while some were inconsistent with the Keynes conjectures.

· Consistent evidence :

I. In few of the studies data of household consumption and income was collected. It was found that household with higher income levels had higher consumption levels too, confirming that MPC >0. It was also found that households with higher income levels had a tendency to save more, confirming that MPC<1. It was also found that households with higher income (rich HH), saved a larger proportion of their income, thus confirming that as income rises APC falls.

II. There were other studies during the periods between World War I and 2. With the data of consumption and income levels between these two periods it was found that during low income periods :

- Consumption and Savings are low, that satisfied the first conjecture

- Ratio of consumption to income was high, that satisfied the second conjecture

-Income and Consumption were so strongly correlated, so no other variable like interest rates was required to explain consumption patterns

· Inconsistent Evidence :

I. The first evidence against the Keynes conjectures was regarded as Secular Stagnation - During the period of World War 2, economists believed that as income levels rises in the long run, the households would consume lesser fraction of their income and save a higher and higher proportion of income thereby increasing the savings rate. They expected that there would not be any investment plans/projects large enough to absorb such higher savings. Thus, with such low consumption levels there would be tremendous fall in aggregate demand and the economy would face a long-term depression. However this did not come to be true and also the 2nd conjecture that as income rises APC falls too did not hold to be true.

II. The second evidence is based on Simon Kuznets data on Income and consumption level collected during 1940’s. It was discovered by him that, the average propensity to consume was more or less constant from one decade to the other decade, despite of increasing levels of income during his period of research. Thus, Keynes second conjecture did not hold true again.

b)

· The Life cycle hypotheses explain that income level varies over an individual’s life. According to this model, savings allow individual consumers to move their income from that time of the life when income levels are high to that time of life when income levels are low. So by this it is meant that consumption does not only depend upon income but also depends upon individual’s wealth. Wealth and income are considered as life time resources. Thus the consumption function looks like :

                                                                                            C = aW + bY

W = Wealth , Y = Income

a: Marginal propensity to consumer out of wealth

b: Marginal Propensity to consume out of income

· Like life cycle hypothesizes, Permanent income hypotheses to predicts that individuals try to smooth consumption levels. However, here rather than emphasizing on an individual life time income, it is assumed that people experience random and short-term changes in their income from one year to another year. Such kind of hypotheses views current income as the summation of transitory income Yt & permanent income Yp.

According to Milton Friedman, the sole determinant of consumption levels is just permanent income. So the consumption function is given by:

                                C = Yp

Consumption puzzle refer to the fact that why some evidence were consistent with Keynes conjecture and why were some inconsistent. It’s the Permanent income Hypothesis which more clearly explains consumption puzzle, as it suggests that Keynes Consumption function uses wrong variables. For e,g, if a household have a higher transitory income it will not have a high consumption level. This suggests, if income is more of transitory in nature, a high income household would have a lower APC. This is very much true for the short-run time series. However, in long-run time series the variability of income is largely permanent, thus with increased income levels they do not save rather consume the increased income.