Consumption and Saving

The Consumption Function describes a relationship between consumption and disposable

income. The concept is believed to have been introduced into macroeconomics by Keynes,
father of Keynesian School of Neoliberal Macroeconomics. Keynes’ consumption function
has come to be known as the ‘Absolute Income Hypothesis’.

Its simplest form is the linear consumption function used frequently in simple Keynesian
models:
C = A+ b Yd
where A is the Autonomous Consumption that is independent of disposable income; in
other words, consumption when income is zero. This maybe necessities or debt for
households. When income is actually zero, this A is dissaving, because it is financed by
borrowing or using up savings.
The term b Yd is Induced Consumption because it depends on income level. As wealth
grow people begin to enjoy better standard of living, being able to incur greater expenses,
also being in a better position to save or invest money to be used as future income.
The parameter b is known as the Marginal Propensity to Consume (MPC), i.e. the percentage
of consumption due to an incremental increase in disposable income. Geometrically, b is the
slope of the consumption function. One of the key assumptions of Keynesian economics is
that this parameter is between zero and one. Also that 1 – MPC is the Marginal Propensity to
Save (MPS) which shows how much of income will be saved by the households.
For poor households MPC is high because they spend most of their earnings and MPS is small
because they are unable to save, while richer households have low MPC and high MPS.
The relationship between MPC and MPS is shown in diagram below. 45 Degree line shows the points
where there is no saving and all earning is consumed.
Keynes also took note of the tendency for the marginal propensity to consume to decrease as
income increases. If this assumption is to be used, it would result in a nonlinear consumption
function with a diminishing slope. Along this curve b (MPC) keep changing (i.e., becomes
smaller), but its range stays between 1 and 0.

Crticisms:
• Keynes’ consumption also known as ‘Absolute Income Hypothesis’, was based
neither on any theoretical foundation nor on any statistical study but on
“psychological rule-of-thumb”. Simon Kuznet statistically examined Keynes’s theory.
He found that short run household data shows a relationship between consumption
and disposable income as hypothesized by Keynes, but this theory fails to explain the
long-run time series data.
• Keynes argues that if everyone individually cuts spending to increase saving,
aggregate saving will eventually fall because one person's spending is someone else's
income. Because increased saving decreases current consumption, it reduces
 aggregate demand and output. This is called “Paradox of thrift”. Such logic may be
meaningful in developed countries going through recession (economic downturn), but
in long run an increase in the saving rate increases capital investment which is critical
for developing countries.
• Finally, the absolute income hypothesis, was criticized for not taking into account the
influence of wealth and the rate of interest on consumption and so for not being
consistent with the micro-economic analysis of consumer behavior.
The Life-Cycle Hypothesis:
Franco Modigliani and his collaborators Albert Ando and Richard Brumberg wanted to solve
the consumption puzzle and tried to explain the conflicting pieces of evidence that came to
light when Keynes’s consumption function was tested.
Modigliani emphasized that consumption varies systematically over people’s lives and that
saving allows consumers to move income from those times in life when income is high to
those times when it is low. This interpretation of consumer behavior formed the basis for his
life-cycle hypothesis.

Example:
One reason that income varies over a person’s life is retirement at about 60, and they expect
their incomes to fall when they retire. Yet they do not want a large drop in their standard of
living, as measured by consumption. They can maintain consumption provided they save
during their working life. Let us see what this motive for saving implies for the consumption
function.

Consider someone who expects to live T years, has wealth W, and expects to earn income Y
until she retires R years from now. What level of C will this person choose if she wishes to
maintain a smooth level of C over her life? The consumer’s lifetime resources are composed
of initial wealth W and lifetime earnings of R.Y. The consumer can divide up her lifetime
resources among her T remaining years of life. We assume that she wishes to achieve the
smoothest possible path of C over her lifetime. Thus, she divides this total of W + RY equally
among T years and consumes each year: C = (W + RY)/T and her consumption function
becomes: C = (l/T) W + (R/T) Y
For example, if T = 60 and R = 30, so her consumption function is
C = 0.017W + 0.5Y
Thus, consumption depends on both wealth and income. An extra 100 rupees of income per
year raises C by 50rupees per year and extra rupee of wealth raises C by 1.7 rupees per year.
If every individual plans C like this, then the aggregate consumption function is much the
same as the individual one. It means, aggregate consumption function depends on both
wealth and income. That is, the economy’s consumption function is:
C = αW +βY, when α = MPC out of wealth and β = MPC out of income.
The MPC out of income is large and the MPC out of wealth is small, close to zero.
Suppose a person receives one time income, like wins a prize bond, this is considered as
transitory income. MPC of transitory income is very small like MPC of wealth because there
is consumption smoothing according to Life Cycle theory.
Wealth in the Life-Cycle Hypothesis

Explanation for Life-Cycle Consumption Patterns

• Diminishing marginal utility of income. If income is high during working life, there is
a diminishing marginal utility of spending extra money at that particular time.
• As it is harder to work and earn money, in old age. Life Cycle enables people to work
more and spend less during their productive years. This resolves Paradox of Thrift
because in the entire population there are both young and old people.

Criticisms of Life Cycle Theory

• Present focus bias – People can find it hard to value income a long time in the future.
Also may lack the self-control to reduce spending now and save more for future.
• It assumes people use up wealth in old age, but often this doesn’t happen as people
would like to pass on inherited wealth to children. Also, there can be an attachment to
wealth and an unwillingness to use it at all.
• Rather than smoothing out consumption, individuals may prefer to smooth out leisure
– working fewer hours during working age and continuing to work part-time in
retirement.
 • In rich countries, benefits for old-age people may provide an incentive not to save
because lower savings will lead to more social security payments by the government.
• In Pakistan there is currently a pensions crisis because the government did not plan
pensions of public sector employees efficiently. In developed countries like the US,
where people plan their own pensions this planning for retirement requires a lot of
effort, forward thinking and knowledge of financial opportunities. Even then pensions
are never completely secure in the US.
Policy Implications:
• There is some evidence that wealthier people have a somewhat lower marginal
propensity to consume out of income. Therefore, macroeconomic policies that shift
income to poor families can also increase overall consumption and stimulate the
economy according to LC theory.
• In developed countries the phenomenon of population aging is happening because of
longer life expectancy as well as lower birth rates and lower population growth rates.
The life cycle theory can be used to deduce that while longer expected life increases
individual and aggregate savings, a lower population growth rate may increase per
capita saving in the short run but reduces it in the long run. Therefore, immigration
from developing countries maybe favorable for increasing aggregate consumption and
savings.
Permanent - Income Theory
Like the life-cycle hypothesis, the permanent-income theory of consumption argues that
consumption is related not to current income but to a longer-term estimate of income, which
Milton Friedman, who introduced the theory, called “permanent income.”
Example
Consider a person who is paid or receives income only once a week, on Fridays. We do not
expect that person to consume only on Friday, with zero consumption on the other days of the
week. People prefer a smooth consumption flow rather than plenty today and scarcity
tomorrow or yesterday.
The idea that consumption spending is geared to long-term, or average or permanent, income
is appealing and essentially the same as the life-cycle theory. Permanent ncome is the steady
rate of expenditure a person could maintain for the rest of his or her life, given the present
level of wealth and the income earned now and in the future.
In its simplest form the theory argues that consumption is proportional to permanent income:
C = c YP
where YP is permanent (disposable) income.
To think about the measurement of permanent income, imagine someone trying to figure out
what her or his permanent income is. The person has a current level of income and has
formed some idea of the level of consumption he can maintain for the rest of his life.
Now income goes up. The person has to decide whether the increase is permanent or merely
transitory. Permanent income may be regarded as ‘the mean income’, determined by the
expected or anticipated income to be received over a long period of time. On the other hand,
Transitory Income consists of unexpected or unanticipated or windfall rise or fall in income.
In any particular case, an individual may know whether an increase is permanent or
transitory. An associate professor who is promoted to professor and given a raise will think
that the increase in income is permanent; a worker who has exceptionally high overtime in a
given year will likely regard that year’s increased income as transitory.
Over time as the economy grows transitory components reduce to zero for the society as a
whole. So, consumption and income values are permanent consumption and permanent
income.
Modern Versions of the PIH
If permanent income were known exactly, then according to the Freidman’s PIH,
consumption would never change. The modern version of the PIH emphasizes the link
between income uncertainty and changes in consumption and takes a more formal approach
to consumer maximization. According to this newer version, changes in consumption arise
from surprise changes in income. Absent income surprises, consumption in one period should
be the same as consumption in period. When there are rational expectations, the surprise is
truly random and unpredictable. So, the Random-Walk Model states that consumption
tomorrow should equal consumption today plus a truly random error.
Recent data suggests that both the Keynesian consumption function and the PIH contribute to
explaining actual consumption behaviour in which there is both excess sensitivity and excess
smoothness of current disposable income. So modern authors have tried to combine the two
theories in a model where half of consumption behavior is explained by current income and
other half by permanent income.
Many criticisms of the PIH emphasize liquidity constraints (limit on the amount an
individual can borrow) because PIH has assumption that consumers can easily borrow or
lend. This insight has led to modern versions of PIH model to account for capital market
imperfections leading to liquidity constraints.
According to the buffer-stock version income fluctuations create considerable downside risk
for the consumer, because the pain caused by a large drop in spending is greater than the
pleasure caused by an equal-size increase in spending. Consumers can avoid having to cut
their consumption sharply in bad times is to save up a buffer stock of assets, which they can
draw on in emergencies. On the other hand, most consumers are impatient; they would prefer
to spend now rather than save for the future. Under these conditions, consumers will have a
“target” wealth level. The target will be the point where impatience exactly balances the
precautionary (or buffer-stock) saving motive.
Policy Implications
The PIH helps explain the failure of transitory Keynesian demand management techniques to
achieve its policy targets. In a simple Keynesian framework MPC is assumed constant, and so
temporary tax cuts can have a large stimulating effect on demand. The PIH framework
suggests that a consumer will spread out the gains from a temporary tax cut over a long
horizon, and so the stimulus effect will be much smaller.