The Theory of Income

Determination
 The circular flow of income

INJECTIONS
Firm
Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

Household WITHDRAWALS
 THE KEYNESIAN REVOLUTION
 Keynes’ rejection of classical theory
◦ rigidities in the labour market
◦ the problem of deficiency of demand
◦ rejection of increased saving as a means of
increasing investment
◦ rejection of a balanced budget
 Keynes’ analysis of employment and inflation
◦ the importance of aggregate demand
◦ the multiplier process
 Assumptions
A single concept of national income (Yd)
A constant level of potential/full
employment national income (Yf)
Existence of unemployment
Constant price level
The Consumption Function
 Absolute Income Hypothesis
• Yd = C + S
C = a + b Yd
– C = current consumption
– a = autonomous consumption
– b = marginal propensity to consume
– Yd = Current disposable income (Y-tax + transfers)
 Absolute Income Hypothesis
Keynes relied on the psychological law that the satisfaction
of “immediate primary needs” is a stronger motive for
consumption than “accumulation.”

For example, if a millionaire and a welfare recipient each

received $500, the millionaire would likely just add the
money to her savings account since her primary needs
are already met.
The welfare recipient, on the other hand, would likely
immediately spend the money on food, clothing,
and shelter.
 Y
120 The consumption function
C

100
Consumption (£bn)

DC = 8
80
DY = 10

60
mpc = DC / DY
50
= 8/10
40 = 0.8

20

0
0 20 40 50 60 80 100 120 140

Y (£bn)
UK Consumption Function (SR)
UK Consumption Function 1957Q1 - 1975Q4

10000
9000
8000
7000
Real Cons Exp

6000
5000
4000
C = 0.6531YD + 1520.8
3000
2000
1000
0
0 2000 4000 6000 8000 10000 12000
Real PDI

4
• Autonomous consumption
– A change in autonomous consumption is unrelated to
income and causes a shift in AE
• Wealth
• Credit
• Expectations
• Age
• Price Levels
– ↓PL → ↑real wealth (savings)
– ↓PL → ↑NX
 Properties

• Value of MPC is constant

• 0<MPC<1

• APC = a/yd + b
 Savings Function

S = Yd – C
= Yd – a-b Yd
S = -a + (1 - b) Yd
• Thus MPS = 1-b
• APS = -a/yd + (1-b)
• MPC + MPS =1
• APC + APS = 1
Consumption ($1000)
50
Yd = C
40
Ctotal
30

20

10
dY ($1000s) Cautonomous
0
20 0 10 20 30 40 50
Savings ($1000)

15 savings
function
10 Dissaving
Saving
5

0
10 20 30 40 50
Yd ($1000s)
-5
C – Yd = 0
-10
 Implications

 As an economy prospers, income goes up and so does

the savings rate (APS).
 Thus, prosperity leads to stagnation
Reasons
 As Y goes up, APC goes down and APS goes up. Thus,
consumption expenditure falls leading to fall in AD.
 Savings do not lead to investment as the opportunities
for investment may not be favorable.
 This leads to increase in inventory, fall in production and
then to stagnation (Secular Stagnation Hypothesis)
 140
Shifts in the Consumption function
C=Yd
120

C3
Consumption (£bn)

100

80 C2

60 C1

40

20

0
0 20 40 60 80 100 120 140
Y (£bn)
 140 Long-run and short-run
Y

120
consumption functionsC long run
Consumption (£bn)

100
C10 years’ time
C5 years’ time
80
Cnow
60

40

20

0
0 20 40 60 80 100 120 140
Y (£bn)
 Early Empirical Successes:
Results from Early Studies
 Households with higher incomes:
▪
 MPC > 0
▪
 MPC < 1
▪
 APC  as Y 
 Very strong correlation between income and consumption
 income seemed to be the main
determinant of consumption
 Objections

– Found valid in cross-section data only.

• Kuznets found a constant APS using time-
series data.
• Great depression has not occurred again.
 The Consumption Puzzle
Consumption function from long
C time series data (constant APC )

Consumption function from

cross-sectional household
data
(falling APC )

Y
 Alterative Models

• Irving Fisher and Inter-temporal Choice

• Life Cycle Income Theory
• Permanent Income Hypothesis
• Relative Income Hypothesis
 Life Cycle Income Theory: Modigliani, Ando and Brumberg

• Consumption depends on a person’s life-time

income and not on the current income.
Irving Fisher and Intertemporal Choice
 The basis for much subsequent work on
consumption.
 Assumes consumer is forward-looking and
chooses consumption for the present and
future to maximize lifetime satisfaction.
 Consumer’s choices are subject to an inter-
temporal budget constraint,
a measure of the total resources available for
present and future consumption
 The basic two-period model
• Period 1: the present
• Period 2: the future
• Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
 Deriving the
intertemporal budget constraint

In the first period:

S = Y1 - C1
(S < 0 if the consumer borrows in period 1)
(S>0, if the consumer consumes less than income)
 Deriving the
intertemporal budget constraint
• Period 2 budget constraint:
C 2 = Y 2 + (1 + r ) S
Here consumption equals the accumulated savings
including the interest earned + income in period II.
To derive the consumer's budget constraint, combine
the above two equation and solve it for C2.

C 2 = Y 2 + (1 + r )(Y 1 - C1)
▪ Rearrange to put C terms on one side
and Y terms on the other:

(1 + r ) C 1 + C 2 = Y 2 + (1 + r )Y1
▪ Finally, divide through by (1+r ):
The intertemporal budget constraint

C2 Y2
C1 + = Y1 +
1+r 1+r

present value of present value of

______________ ____________

slide 26
 The intertemporal budget constraint
C2 C2 Y2
C1 + = Y1 +
1+r 1+r
The budget
constraint
shows all (1 + r )Y 1 + Y 2 _____
Consumption =
income in both
combinations periods
of C1 and C2
C1=Y1
that just
exhaust the Y2 C2 =Y2
_______
consumer’s
resources.
C1
Y1
Y 1 + Y 2 /(1 + r )
 The intertemporal budget constraint
C2 C2 Y2
C1 + = Y1 +
The slope of 1+r 1+r
the budget
line equals
1
(1+r )

Y2

C1
Y1
 Consumer preferences
Higher indifference
An IC shows all C2 curves represent
combinations of higher levels of
happiness.
C1 and C2 that
make the
consumer equally
happy.
Y

Z
X IC2
W
IC1
C1
 Consumer preferences
C2 The slope of an
indifference curve
at any point equals
Marginal rate of the MRS
substitution (MRS ): the at that point.
amount of C2 consumer
would be substituting for 1
one unit of C1 MRS

IC1
C1
MRS is negative

slide 30
 Optimization
C2
The optimal (C1,C2) is At the optimal
where the budget line point, MRS =1+r
just touches the
highest indifference
curve.
E

C1

slide 31
 How C responds to changes in Y
C2 An increase in Y1 or Y2
shifts the budget line
Provided they are both
normal goods, C1 and C2 outward.
both increase, when
income rises

C1

slide 32
 Keynes vs. Fisher
 Keynes:
current consumption depends only on
current income
 Fisher:
➢Current consumption depends on the resources the
consumer expects over his lifetime.
➢The timing of income is irrelevant
because the consumer can borrow or lend between
periods.
➢Consumption depends on the present value of
current and future incomes.
Y2
 i.e. Y1 +
1+ r slide 33
 How C responds to changes in r
C2
An increase in r
pivots the budget
line around the
point (Y1,Y2 ).
B

A
Y2

Y1 C1
 How C responds to changes in r
• If consumer is a saver, the rise in r makes him better off,
which tends to increase consumption in both periods.
• The rise in r increases the opportunity cost of current
consumption, which tends to reduce C1 and increase C2.
• Both Income and substitution effects  C2.
Whether C1 rises or falls depends on the relative size of the
income & substitution effects.
We treat consumption in both periods as normal goods.
 Constraints on borrowing
• In Fisher’s theory, the timing of income is irrelevant
because the consumer can borrow and lend across
periods.
• Example: If consumer learns that her future income will
increase, she can spread the extra consumption over both
periods by borrowing in the current period.
• However, if consumer faces borrowing constraints or
“liquidity constraints”, then she may not be able to
increase current consumption and her consumption may
behave as in the Keynesian theory (Current Consumption
depends on current income) even though she is rational &
forward-looking.
 Constraints on borrowing
The borrowing C2 Budget
constraint
constraint takes the
form: The budget line
C1  Y 1
______
with a
borrowing
constraint

Y2
Borrowing
constraint

Y1 C1
Consumer optimization when the borrowing
constraint is not binding
C2

The borrowing
constraint is not
binding if the
consumer’s
optimal C1<Y1
___________.

Y1 C1
Consumer optimization when the borrowing
constraint is binding
The optimal C2
choice is at point
D.
But since the
consumer cannot
borrow, the best
he can do is point E
E. D

Y1 C1
 The Life-Cycle Hypothesis
Franco Modigliani (1950s)
• Fisher’s model says that consumption depends
on lifetime income, and people try to achieve
smooth consumption.
• The LCH says that income varies systematically
over the phases of the consumer’s “life cycle”.
• Saving allows the consumer move income from
times when it is low to when it is high to achieve
smooth consumption.

slide 40
 The Life-Cycle Hypothesis
• The basic model:
W = wealth
Y = Income one earns until one retires
(assumed constant) (average income)
R = number of years until retirement
T = lifetime in years (one expects to live)
• Assumptions:
– zero real interest rate (for simplicity)
– consumption-smoothing is optimal
 The Life-Cycle Hypothesis
• Lifetime resources = W + (R x Y)
• To achieve smooth consumption, consumer divides her
resources (W + RY) equally over time (T years) and each year
consumes
C = (W + RY)/T
Or
C = W/T + (RY)/T
= (1/T)W + (R/T)Y
1𝑊 𝑅𝑌
𝐴𝑃𝐶 = +
𝑇 𝑌 𝑇𝑌
The Y in numerator may be treated as average Y.
 Example
If the consumer expects to live for 50 years more and works for 30 years of them,
then T =50 and R = 30.
Then her consumption function is
C = 0.02W + 0.6Y
0r
C = aW + bY
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to consume out of income
 Example Cont…
• A person starts working when she is 30 years
old, works till 65, earns an average annual
income of Rs 500000 and expects to die at the
age of 80.
• By LCT, her consumption in any year between
30 to 80 years
65 − 30
500000 = 0.7 500000 = Rs 350000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
80 − 30
 Example Cont…
• If this person earns Rs 300000 annually when
she is 30-40 years, Rs 450000 when she is 40
to 55 years and Rs 600000 when she is 55 to
65 years, annual consumption will be
65 − 30 300000 × 10 + 450000 × 15 + 600000 × 10
= 0.7 450000 = Rs 315000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
80 − 30 10 + 15 + 10
 Example Cont…
• If the said person wins a lottery of Rs
10,00,000 when she is 60, her annual
consumption will in increase by
1000000
= Rs 20000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
80 − 30

• If she gets promotion at the age of 50 and her

salary increases by Rs 100000 per annum, her
annual consumption will rise by
100000 × 15
= Rs 30000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
80 − 30
 Example Cont..
• If her annual net wealth is Rs 100000, her
consumption will increase by
100000
= Rs 2000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
80 − 30
 Implications
• For any given level of wealth, the model yields
a conventional consumption function.
• However, the intercept is not a fixed value.
• Intercept is aW and thus depends on wealth.
 The Life Cycle Consumption Function

b
1
aW

Y
 Implications
The LCH can solve the consumption puzzle:
▪ The APC implied by the life-cycle consumption
function is
C/Y = a(W/Y)+ b
▪ In the short-run, across households, wealth does not
vary as much as income, so high income households
experience low APC.
▪ In the long-run, aggregate wealth and income grow
together, resulting in constant W/Y and constant
APC.
 Implications put differently
• For a given wealth, LC consumption function
behaves similar to what is Keynes’.
• This holds only in the short run, as wealth is
constant.
• In the long run, C function shifts upward that
prevents APC to fall as Y increases.
 Implications of the Life-Cycle Hypothesis
$
The LCH
implies that
saving varies Wealth
systematically
over a person’s
lifetime. Income

Saving

Consumption Dissaving

Retirement End
begins of life
 Limitations
• Future incomes are unknown and thus the life
time average income may be uncertain.
• Capital market may not be quite conducive for
borrowing or savings.
 The Permanent Income Hypothesis
(Milton Friedman,1957)
• While LCH suggests that income follows a
regular pattern over a person’s life time, the
PIH emphasizes that people experience
random and temporary changes in their
incomes from year to year.
 The Hypothesis
• The PIH views current income Y as the sum of two
components:
Permanent Income: Y P (average income, which
people expect to persist into the future): Average
Income
Transitory Income: Y T (temporary deviations from
average income): Random Deviation from Average
Income

Y = Yp + Yt
• A good education provides permanently
higher income
• A good monsoon provides transitorily higher
income.
• Consumption is a function of permanent income.
C = a Yp
where a is the fraction of permanent income that
people consume per year.
C is proportional to Yp.
• Consumers use saving & borrowing to smooth
consumption in response to transitory changes in
income.
• Consumers spend their permanent income (salary rise
annually) and save their transitory income (lottery).
 Implications
• The PIH can solve the consumption puzzle: C depends on Yp and not on
current income.
C
APC = = a Yp / Y
Y
• APC depends on the ratio of permanent income to current income.
• When current income rises temporarily above Yp, APC temporarily falls
and vice versa.
▪ To the extent that high income households have higher transitory income
than low income households, the APC will be low.
▪ Saving ratios are high during boom and low during recession.
▪ When transitory income is positive, Y > Yp and Yp/Y < 1.
▪ Over the long run, income variation is due mainly if not solely to variation
in permanent income, which implies a constant APC.
 PIH vs. LCH
• In both, people try to achieve smooth
consumption in the face of changing current
income.
• In the LCH, current income changes systematically
as people move through their life cycle.
• In the PIH, current income is subject to random,
transitory fluctuations.
• Both hypotheses can explain the consumption
puzzle.

slide 60
 Relative Income Hypothesis
(Duesenberry)
Defining Relative Income
• Current income relative to the past peak
income
• Own income relative to the average income in
the neighborhood/nation
 How it works?
• Consumption determines the standard of living and by habit,
people enjoy raising their standard but hate letting it slide
downwards.
• When income rises, they raise their consumption but they
refuse to reduce their consumption when income falls.
• Ratio of the household's current income to the past peak
income acts as an additional determinant of its current
consumption.
• If this ratio falls, ceteris paribus, the current consumption
goes up and vice versa.
 Implications of RIH
• An economy’s saving ratio rises slower than
otherwise during the time of prosperity and to
fall slower than otherwise during recession.
• Hence, prosperity may not lead to recession.
 Random-Walk Hypothesis
(Robert Hall,1978)

• based on Fisher’s model & PIH, in which forward-

looking consumers base consumption on expected
future income
• Hall adds the assumption of rational expectations, that
people use all available information to forecast future
variables like income.

slide 65
 The Hypothesis
• If PIH is correct and consumers have rational expectations,
then changes in consumption over time is unpredictable
• Consequently, consumption should follow a random walk.
• A change in income or wealth that was anticipated has
already been factored into expected permanent income, so
it will not change consumption.
• Only unanticipated changes in income or wealth that alter
expected permanent income will change consumption.
 Implications

If consumers obey the PIH and have rational

expectations, then only unexpected policy
changes will affect their consumption
 The Psychology of Instant Gratification
(David Laibson)
• Theories from Fisher to Hall assumes that
consumers are rational and act to maximize
lifetime utility.
• Recent studies by David Laibson and others
consider the psychology of consumers.

slide 68
 The Psychology of Instant Gratification

• Consumers consider themselves to be

imperfect decision-makers.
– E.g., in one survey, 76% said they were not saving
enough for retirement.

• Laibson: The “pull of instant gratification”

explains why people don’t save as much as a
perfectly rational lifetime utility maximizer
would save.

slide 69
 Two Questions and Time Inconsistency
1. Would you prefer
(A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer
(A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered A to question 1, and B to
question 2.
A person confronted with question 2 may choose B.
When he is confronted with question 1, the pull of instant
gratification may induce him to change his mind.

slide 70
 Summing up
• Keynesian consumption function:
C = a + bY
where only current income (Y) mattered.
• Other models advocate that other things should be included:
– expected future income (permanent income model)
– wealth (life cycle model)
– interest rates (Fisher model)
– but current income should still be present (due to borrowing
constraints)
– Consumer Expectations
– Income/wealth distribution
– Credit availability

slide 71