Like Duesenberry’s RIH, Friedman’s hypoth­esis holds that the basic relationship between consumption and income is proportional.But according to Friedman, Consumption de­pends neither on ‘absolute’ income, nor on ‘relative’ income but on ‘permanent’ income, based on expected future income.
In other words,The permanent income hypothesis is a theory of consumer spending stating that people will spend money at a level consistent with their expected long-term average income.
Thus, he finds a strong relationship between Consumption and permanent income.
In permanent income hypothesis,it shows the relationship between permanent Consumption and permanent income.

ASSUMPTIONS :-

1 There is no correlation between temporary and permanent income.

2 There is no correlation between permanent and temporary consumption.

3 There is no correlation between temporary consumption and temporary income.

4 Only changes in fixed income allow consumers to Provide adjustments.

Explanation of Permanent Income Hypothesis :-

Friedman divides the current measured income into two components : permanent income (Yp) and transitory income (Yt).

Thus, Y = Yp + Yt.

Permanent in­come (Yp) may be defined as ‘the mean income’, that is determined by the expected or measured income to be received over a long period of time.
And transitory income includes unexpected or sudden income which is may be unanticipated.

Similarly,Milton Friedman divided the Consumption into two components .i.e, permanent consumption (Cp) and transistory consumption (Ct).

Thus, C = Cp + Ct.

Permanent consumption (Cp) may be regarded as compulsory Consumption which is independent from the level of income (e.g-food ,house, rent, etc.).

Transistory consumption (Ct) may be defines as unanticipated or sudden spendings which could not be expected in future (e.g- accidents, marriage, illness etc.)

The basic or important argument is that perma­nent consumption depends on permanent in­come. The relationship of PIH is that permanent consumption is proportional to permanent income that exhibits a fairly con­stant APC.

That is, Cp = kYp........ (1)

Where k is con­stant and equal to APC and MPC.
As we look at the Assumption,Friedman assumes that there is no correlation between Yp and Yt, between Yt and Ct and between Cp and Ct. That is

RYt. Yp = RYt . Ct = RCt. Cp = 0.

But strong correlation between Yp and Cp exist.
Since Yt is uncorrected with Yp. Then the average transitory income would be equal to zero of all income groups.This is similar for the transitory components of consump­tion.Thus, for all the families taken together the average transitory income and average transitory consumption are zero.Thus,
Yt = Ct = 0.
Now it follows that

Y = Yp and C = Cp

Since the individual's measured income or current income is Y, it can be more or less than his permanent income in any period.This happens because these families had enjoyed unexpected in­comes thereby making transitory incomes positive and Yp<Y. Similarly, for a sample of families with below-average measured in­ come, transitory incomes become negative and Yp>Y.

Now take permanent income which is based on time series. Friedman believes that permanent income depends partly on current income and partly on previous period’s income. This can be measured as

Ypt = aYt + (1-a) Yt-1........(2)

where Ypt = permanent income in the current period, Yt = current income in the current period, Yt-1 = previous period’s income, a – ratio of change in income between current period (t) and previous period (t-1).

This equation tells that permanent income is the sum of current period’s income (Yt) and previous periods income (Yt-1) and the ratio of income change between the two (a). If the current income increases at once, there will be small increase in permanent income.

By integrating equations (1) and (2), short-run and long-run consumption function can be explained as

C t = kYpt = kaYt + k (1-a) Yt-1 …(3)

Where Ct  = current period consumption, ka = short-run MPC, k = long-run MPC and k (1-a) Yt-1, is the intercept of short-run consumption function.

Acc. To Friedman, k and ka are different from one another and k > ka. Further, k = 1 and ka = 0

Equation (3) tells that consumption depends both on previous income and current income. Previous income is important for consumption because it helps in forecasting the future income of people.

Explanation through diagram :-

Given above, assumptions give the explanation of the cross-section results of Friedman’s theory that the short-run consumption function is linear and non-proportional, i.e., APC > MPC and the long-run consumption function is linear and proportional, i.e., APC = MPC.

Above figure explaines that
permanent income hypothesis of Friedman where CL is the long-run consumption function which represents the long-run proportional relationship between consumption and income of an individual where APC = MPC. Cs is the non- proportional short-run consumption function where measured income includes both permanent and transitory components.

At OY income level where Cs and CL curves coincide at point E, permanent income and measured income are identical and so are permanent and measured consumption as shown by YE. At point E, the transitory factors are non-existent. If the consumer’s income increases to OY1 he will increase his consumption consistent with the rise in his income.

For this, he will move along the Cs curve to E2 where his measured income in the short-run is OY1 and measured consumption is Y1E2. The reason for this movement from E to E2 is that during the short-run the consumer does not expect the rise in income to be permanent, so APC falls as income increases.

But if the OY1 income level becomes permanent, the consumer will also increase his consumption permanently. Now his short-run consumption function will shift upward from Cs to CS1 and intersect the long-run consumption function CL at point E1.

Thus the consumer will consume Y1E1 at OY1 income level. Since he knows that the increase in his income OY1 is permanent, he will adjust his consumption Y1E1 accordingly on the long-run consumption function CL at E1 where APC = MPC

Related article:- relative-income-hypothesis.

Introduction :- According to keynesian Current level of income determines the consumption of an individual and also society.

He emphasised that absolute size of income determines the consumption.
This theory is known as absolute income hypothesis .In this hypothesis, according to him, as income increases consumption increases but not by as much as the increase in income..i.e. 0<APC<1.

After that,James Duesenberry has propounded that consumption hypothesis which is depends on income of an individual relative to incomes of others rather than the absolute size of his own income.His theory called relative income hypothesis of consumption function.
according to him, the consumption of a person does not depend on his current income but on certain previously reached income level.Therefore,the Consumption of a  individual also depend upon the other.
Duesenberry says strong tendencies exist in our society for people to emulate their neighbours and to strive toward a higher standard of living.As result, if the incomes of individuals increase so as to leave the distribution of income unchanged, consumption increases in proportion to the increase in income.

According to Duesenberry, if we want to understand the problem of consumer behavior in real, then we have to recognize the social nature of the consumer behavior from the beginning.

Click on it 👉:- absolute-income-hypothesis. 👈

DUESENBERRY EFFECT OR DEMONSTRATION EFFECT :-

The tendency It is about constantly rising towards higher consumption levels and getting richer Compete with the consumption structure of neighbors and peers. Thus consumer's preferences of the Consumption depend on each other. This is called the Dussenberry Effect or Demonstration Effect.

However, in some communities
Consumption expenditure determines through the difference in people's relative income. A rich individual's APC will be relatively low as he will need a small portion of his income to maintain his consumption structure. On the other hand, relatively poor individual will have higher APCs as they strive to reach the consumption standards of their neighbors or peers. This clarifies the long-term stability of the APC This is because the overall low and high APC will be balanced. Such as Even if the absolute amount of income in a country is higher, it will still affect the economy as a whole APC will remain stable at the highest neutral level of revenue.

The second part of Dusenbury's theory is the past peak of income hypothesis that explains short-term fluctuations in consumption function And refutes Keynes's assumption that the consumer relationship is reversible. This Establish,the hypothesis that consumption will increase and Slowly adjust to a higher level during the prosperity period.Onces people Reach a certain high level of income and Consumption.they get used to this standard of living. Even in a recession, they are unwilling to give up their consumption structure.

RATCHET EFFECT:

The other significant part of Duesenberry’s relative income hypothesis is that it suggests that when income of individuals or households falls, their consumption expenditure does not fall much. This is often called a ratchet effect.

In Dusenbury's words, it is easier for a family to control higher expenses in the beginning, but it is more difficult to reduce expenses at a higher level.it's just because of demostration effect.People do not want to show to their neighbours that they no longer afford to maintain their high standard of living.

Now we will discuss relative income hypothesis through the diagrm. CL is a long run Consumption function and
Cs1 and Cs2 are short-run consumption functions.Assume a OY1 is a maximum level of income .At the level where consumption is E1 Y1. Now Income falls to OY0. Because of People are used to the standard of living at the OY1 level of income. Therefore they
Will not reduced their Consumption to E0 Y0 level.they go backwards on the Cs1 curve and they Will reach the C1 point and remain at the C1 Y0 level of consumption.
when recovery period begins, then the income increases to the level of the previous income oY1 .But consumption gradually increases from C1 to E1 along the Cs1 curve.
This is because people will re-establish their previous level of savings.If income increases at the OY2 level, the consumer has the new short-run consumption function Cs2 along with C1 curve will move upwards from E1 to E2.
When recession will come At OY2 level of income, then income will fall to OY1 level. Then consumption will fall from E2 to C2 along with Consumption curve Cs2.
But in the long run during the recovery Consumption will increase along with the long-term consumption function CL until it reaches the short-term consumption function Cs2.
Here we can see that when income increases in long run , short run Consumption function also increases.But when income falls, Consumption goes down Sliding does not reach the first level.

CRITICISMS:-

1)No Proportional Increase in
Consumption:-

The Assumption of relative income theory is that there is proportion increases in income and consumption. But an increase in income on full employment does not always lead to a proportional increase in consumption.

2)No Direct Relation between
Consumption and Income- This principle is based on the assumption that
There is a direct correlation between income and consumption but this is not supported on the basis of experience. Consumption does not always decrease as a result of the trade recession. For example 1948-49
And consumption did not decline during the 1974-75 trade recession.

3)Distribution of Income not Unchanged:-
The theory presented is based on the assumption that there is a change in the overall income level Even so, owning one is still beyond the reach of the average person. If your income increases At the same time income is redistributed in the direction of greater equality, then relatively poor
And the APC of all those belonging to relatively wealthy families will decrease. like this When revenue increases, the consumption function will not move upwards from Cs1  to Cs2.

4)Reversible Consumer Behavior-
According to Michael  Evans, "consumer behavior has Slightly changeable  over time rather than completely changeable . Then as much time passes as the previous maximum level (peak) ,The last maximum revenue level will have an equally small effect on current consumption".If we also know that a consumer has reached their previous highest income level And how it was spent, it is still not possible to know how it is now
Will consume.

5). Neglect of Other Factors:-
It is based on the Assumption that changes in consumer's expenditure is correlated with the previous maximum lavel of income. This theory is weak from this point of view that Ignoring urbanization, consumer age,. Influencing changes in structural behavior, new consumer, other factors such as asset arrival perceptions, etc.

Introduction :-

the consumption function was first introduced by John Maynard Keynes in 1936.
His analysis is related to a simpler version of the consumption process that forms only the more quantitative aspect of his idea,which is
popularly known as absolute income hypothesis (AIH).
This theory,which puts forward the idea that consumption will rise as income Rises but not necessarily at the same rate ,which comes from his fundamental psychological law of Consumption.

The keynesian consumption function written as :-

C = a + bY.     

Where "a" is constant which measures Consumption at zero level of current disposable income.

"b" is the marginal propensity to consume(MPC) and Y is the current disposable income.

According to keynesian aggregate consumption is a function of current disposable income.

(disposable income :-  the personal income after excluding the current taxes.)

In this hypothesis a non proportional relationship (APC> MPC) between consumption and income exist because of psychological law of consumption such that 0<MPC<1 and MPC<APC.

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PROPERTIES OF THIS CONSUMPTION FUNCTION :-

1)Higher income leads to higher consumption because of positive marginal propensity to consume. (0<MPC<1)

2)Average propensity to consume(APC) will decline as income Rises.

3) The consumption function will static in short run and the long run both

4) Consumption expenditure increases or (decreases) with income increases or (decreases) but not in same ratio.

Explanation with diagram :- 

At x-axis we have taken income amd at y-axis we have taken Consumption
Here, C = a + bY is a short run Consumption function. At point E on curve C  at income level Y1 ,at that point APC>MPC.Here we can see that the change in income is more than the change in Consumption.This shows dis-proportion Consumption function.

At income level OY0,at point E0 represents APC (OC0/OY0).). Below the income level consumption is more than income .Above the income level OY0, consumption increases less than proportionately with income so that APC declines and it is less than one.

EMPIRICAL OBSERVATIONS :-

This consumption function derived from the empirical time series data from 1929 - 1944.

In this impirical study they found that families with higher income level consume more which confirm MPC is greater than zero but less than one
It was also found that families with higher income level save more and consumed a smaller proportion of income which confirm that APC falls as income increases.

THE CONSUMPTION PUZZLE :-

A number of empirical studies based on 

cross section budget figures and time series in the late 1930 and 1940 verified Keynesian consumption income relationship which has come to be known as absolute income hypothesis.
It led to formation of stagnation thesis around 1940 which led to believe that as income grow in the economy household would save more and consume less.
As a result, overall demand will fall short of output, and if government spending does not grow at a faster rate than revenue, the economy will stagnate.After World War II, the rate of inflation in the economy was less than stagnant, even when government spending fell.
So Keynesian consumption function was proved wrong.This is because government bonds have been converted into liquid assets by the family since World War II to meet consumer demand for goods.

Important puzzle about consumption function appointed by KUZNET,(a Nobel Prize winner in Economics) he contrary to keynesian proposition that average propensity to consume (APC) falls with increase in income .he found from statical empirical study of consumption of the economy of the USA that average propensity to consume had remained constant Even after the increase in income.
In 1946, Kuznets studied the consumption and income figures for the United States during the period 1868 - 1938.
He estimated the consumption function for this period as 0.9.’

Two conclusions can be drawn from the statistics :-

1)In long run there was no difference between MPC and APC, that is APC= MPC.the long run consumption function equation is C = bY.
There was no autonomous consumption in long run i.e, "a"=0

2)The year in which the APC is less than the long-term average was called the boom period and the year in which the APC is above the long term was called the boom period. i.e,.APC>MPC in short run.

Introduction :- 

Consumption function represents the functional relationship between total consumption and gross national income .It was introduced by the british economist John Maynard Keynes,in 1936.
On the behalf of it's importance and its subjective and objective determinants, it is a same as Keynes's psychological law of consumption.

MEANING OF CONSUMPTION FUNCTION :-

On the basis of the study we simply define the consumption function that it is a relationship between consumption and income . It is expressed as : C= f(Y)
where C is a consumption and Y is a income.
Here C is dependent and Y is the independent variable.
this relationship is based on the assumption of "other things being equal or remains same".This relation implies that consumption depends on income.

Consumption function is an increasing function of income ,i.e., consumption expenditure increases with the increase in income.
when the income is zero during the depression, people spend out of their past savings on consumption because they must eat in order to live.
So here we can say that the some part of the consumption is independent from the income.That consumption called autonomous consumption.

Its simplest form is the linear consumption function used frequently in simple keynesian model.

C= a + b×Y(d)

where "a" is autonomous consumption that is independent of disposable income.

The perimeter "b" is known as marginal propensity to consume(MPC) And Y(d) is a current disposable income.

The term b×Y(d) is the induced consumption that is influenced by the level of income.

Income and Consumption

In the diagram at x-axis we have taken income and y-axis we have taken consumption. 45° line is the unity line where at all levels of income and consumption are equal to each other.
Its upward slope to the right indicates that con­sumption is an increasing function of income. В is the break-even point where C=Y. When income rises to 0Y1 con­sumption also increases to 0C2, but the increase in consumption is less than the increase in income, C1C2< Y1Y2 The portion of in­come not consumed is saved as shown by the vertical distance between 45° line and С curve.

Characteristics of Consumption Function:

A study of the short run consumption function reveals the following four characteristics:

1) There is a break-even level of income. It is the level of income at which households spend all of their income on consumption goods, neither more nor less, i.e., at which saving is zero.

2. Below the critical (break-even) level people plan to spend in excess of their current income.

This can be done through the:

Either by borrowing or By dis-saving,

3. Once income crosses the break-even level, peo­ple plan to consume only a portion of their income and to save the remaining portion of it.

4. If income increases (decreases), consumption spending will also increase (decrease) though not pro­portionately.

PROPERTIES OF CONSUMPTION FUNCTION

The consumption function has two properties:

1) The average propensity to consume (APC)

2) The marginal propensity to consume(MPC)

APC and MPC

(1)THE AVERAGE PROPENSITY TO CONSUME :-  

the average propensity to consume (APC) is the fraction of income spent. It is computed by dividing consumption by income, or APC= C/Y
It is expressed as the percentage or proportion of income consumed.

Sometimes, disposable income is used as the denominator instead, so APC =C/Y-T', where C is the amount spent, Y is pre-tax income, and T is taxes.

(2)THE MARGINAL PROPENSITY TO CONSUME :- 

Marginal propensity to consume (MPC) is the extra consumer spending arising from an increase in national income.it is may be de- fined as the ratio of the change in consumption to the change in income.
MPC — ∆C/∆Y.

MAJOR FACTS OF CONSUMPTION FUNCTION :-

Induced consumption :-consumption depends on income and varies with income changes it is called induced consumption.In Keynes’ theory of income determination variations in consumption are explained by changes in national income.

The Aggregate Consumption Function :-By adding up the consumption functions of all households we arrive at the aggregate consumption function.it shows how the total desired consumption spending of all households varies with national income.it shows the behavior of the different individuals.

DETERMINANTS OF CONSUMPTION  FUNCTION :-

Acc to Keynesian,there are two factors,that influences the consumption function.

1) Subjective factors

2) Objective factors

SUBJECTIVE FACTORS :- Subjective factors are internal factors to the economic system.These factors are the characteristics of the short run.That includes  human nature, social practices and institutions and social arrangement.

(1) Individual Motives:

They are:

(i)To build reserves.

(ii) For precautionary motive amd anticipated future needs, i.e., old age, sickness, accidents, etc.;

(iii)Motive to enjoy an enlarged future income by way of interest and appreciation.

(iv) Motive to improve the standard of living;

(v) Motive to enjoy a sense of independence and power to do things.

(vi) Motive to bequeath a fortune

(2) Business Motives:

Consumption and investment are influenced by the business motives. The behavior of All industries and carporations influences the economic system.

(i) Enterprise, who wants to do big things and to expand there business.

(ii) Cash, for overcome from the emergencies and difficulties successfully;

(iii) Income raise, to make large income and to show successful management.

(iv) Financial prudence, that provide adequate financial resources against depreciation and obsolescence, and  debt redemption.

2. OBJECTIVE FACTORS:The objective factors are the external to the economic system. They may, therefore, undergo rapid changes and may cause marked shifts in the consumption function.

1.Wage Level:

if the wages increase then consumption also increases and vise versa.the workers will spend more (less) due increase (decrease)their  income ,thats why consumption curve shifts upward (downward).

2.Gains or Losses:

Unexpected changes in the stock market leading to gains (losses) tend to shift the consumption function upward (downward). 

3. Fiscal Policy:

Changes in fiscal policy in terms of taxation and public expenditure affect the consumption function. Heavy taxation will affects badly to the consumption and vise versa.

4. The Distribution of Income:

Distribution of income will also affects the consumption.Incorrect distribution of income will decreases the Consumption and vise versa.

5. Attitude toward Saving:

If an individual wants to more cash in hand or savings then consumption will decreases because of less spend on the commodity and vise versa.

Effective demand leads to increase in production and production creates income,then income creates employment.

because of inter-relationship among effective demand, output, income and Employment, therefore Keynes assume that employment is a function of income.

Y=f(N).      Y-income,N-employment

Effective demand signifies money in terms of consumption of goods and services and investment.

Consumption of goods and services and investment are the combinations of total expenditure.the total expenditure is equal to the national output which is equal to the national income.Therefore, effective demand is equal to total expenditure as well as national income and national output.

He criticized "classical theory of employment" in his book "General Theory of Employment, Interest and Money".
Acc to him market forces cannot attain equilibrium themselves .they need an external support for achieving it. This is why Keynes view of employment more reliable than classical.

The Keynes theory of employment was based on short run phenomenon. In the short run,Acc to him, the factors of production, such as capital goods, supply of labor, technology, and efficiency of labor, remain unchanged while determining the level of employment. So the level of employment is dependent on national income and national output.

If there is any increase in national income lavel,there would be an increase in employment level and vise versa.

PRINCIPLE OF EFFECTIVE DEMAND

According to keynesian theory of employment, effective demand is a situation where aggregate demand and aggregate supply equals to each other.

ED :- Aggregate demand=Aggregate supply

As we mentioned that keynesian theory of employment is a short run phenomenon therefore aggregate supply would be fixed factors in short run.
Keynes focused only on the aggregate demand to overcome the depression and unemployment.According to him, an increase in the aggregate demand would increase the level of employment and vice-versa.Total employment of a country would be increase with the help of increase in effective demand of the country and vise versa.

Effective demand affects employment level of a country, any mismatch between income and consumption leads to decline in Employment.

Any increase in the national income leads to increase in consumption  , but the increase in consumption rate is relatively low as compared to the increase in national income. Low consumption rate declines the effective demand.

Therefore, the gap between the income and consumption rate should be reduced by increasing the number of investment. After increase in investment, effective demand also increases, which further helps in reducing unemployment and achieving full employment condition.

In short run period, total output or total national income depends on the level of employment the level of employment depend upon effective demand.

ASSUMPTIONS

1. All factors of production are in perfectly elastic supply so long as there is any unemployment.

2. All unemployed factors are homogeneous, perfectly divisible and interchangeable.

3. there is a existence of under employment equilibrium in the economy.

4. There are constant returns to scale so that prices do not rise or fall as output increases.

5. Diminishing marginal productivity.

6. Effective demand and quantity of money change in the same proportion so long as there are any unemployed resources.

7. It assume short run and perfect competition in the economy.

PRINCIPLE OF EFFECTIVE DEMAND

Keynes used two key terms, that are, aggregate demand and aggregate supply, for determining effective demand. Aggregate demand and aggregate supply together determine effective demand, which further helps in estimating the level of employment of an economy at a particular period of time.

Aggregate supply (AS) :- Aggregate supply refers to the total amount of money that all organizations in an economy should receive from the sale of output produced by employing a specific number of workers.

AS = C+S.       C-Consumption, S - Savings

Aggregate demand (AD):- Aggregate demand refers to the total amount which all the producer expect to receive by selling the output produced at a given level of employment.As result, the increase in the employment level would increase the aggregate demand price.

AD= C+I.        C- consumption,.  I-investment

(Must read -the-classical-theory-of-employment )

Determination of Equilibrium Level of Employment:

The aggregate demand (AD) and aggregate supply (AS) curve are used for determining the equilibrium level of employment,

In diagram,AD represents the aggregate demand curve, while AS represents the aggregate supply curve.

At x-axis we have taken employment level and at y-axis we have taken receipts (national income)
at AS curve, the frim would employ OA1 number of workers, when they receive OF amount of sales receipts. On the other hand, in case of AD curve, the frim would employ OA1 number of workers with the expectation that they would produce OG amount of sales receipt for them.

Here aggregate demand exceeds aggregate supply.here at OA1 (employment level) national income is more than narional output.For the point of  OI and OA3-here aggregate supply exceeds aggregate demand.there is not an equilibrium situation for both.

On the other hand,at OA2 and OH , aggregate demand and aggregate supply cut each other at E ,here nariaonl income (OH) is equal to national output (OA2).
So E is the point of equilibrium where effective demand justify the level of employment.