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ABSOLUTE INCOME HYPOTHESIS
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.
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.
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.
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.
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.
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.’
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
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.
and CL= long run Consumption curve i.e, APC=MPC
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