Consumption Theories (Keynes, Permanent Income, Relative Income, Life Cycle)

1) Why study consumption functions?

Consumption is the largest component of aggregate demand. Consumption theories explain:

• how consumption responds to income,
• short-run vs long-run behavior,
• implications for saving, multipliers, and policy.

2) Keynes’ Absolute Income Hypothesis (AIH)

Keynes proposed:

where:

• $a$ = autonomous consumption,
• $b$ = MPC, $0<b<1$.

Implications:

• $C$ increases with current income $Y$.
• APC falls as income rises:

As $Y$ increases, $a/Y$ falls, so APC declines.

Short-run focus: consumption strongly linked to current income.

3) Kuznets puzzle (motivation for later theories)

Empirical observation (long run): APC is roughly stable. But Keynes AIH predicts APC should decline as income rises.

This led to modern consumption theories:

• Permanent Income (Friedman),
• Relative Income (Duesenberry),
• Life Cycle (Modigliani).

4) Permanent Income Hypothesis (PIH) – Friedman

4.1 Key idea

People base consumption on permanent income (expected long-term average income), not purely current income.

Income decomposed:

• $Y^P$: permanent income
• $Y^T$: transitory income