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### Keynes’ consumption function :the absolute income hypothesis

Keynes in his General Theory postulated that aggregate consumption is a function of aggregate current disposable income. The relation between consumption and income is based on his Fundamental Psychological Law of Consumption which states that when income increases consumption expenditure also increases but by a smaller amount.

The Keynesian consumption function is written as

C = a + cY a > 0, 0 <c < 1

where a is the intercept, a constant which measures consumption at a zero level of disposal income; c is the marginal propensity to consume (MPC); and Y is the disposal income.

The above relation that consumption is a function of current disposableincome whether linear or non-linear, is called the absolute income hypothesis.

This consumption function has the following properties:

1. As income increases, average propensity to consume (APC = C/Y) falls.

2. The marginal propensity to consume (MPC) is positive but less than unity (0 <c < 1) so that higher income leads to higher consumption.

3. The consumption expenditure increases (or decreases) with increase (or decrease) in income but non-proportionally. This non-proportional consumption function implies that in the short-run average and marginal propensities do not coincide (APC >MPC). 4. This consumption function is stable both in the short-run and the long- run.

This consumption function is explained in

Fig. 1 where C = a + cY is the consumption function. At point E on the C curve the income level is OY1. At this point, APC >MPC where APC = OC1/OY1 and MPC = ∆C/∆Y = ER/REO.

This shows disproportional consumption function. The intercept a shows the level of consumption corresponding to a zero level of income. At income level OY0 where the curve C intersects the 45° line, point E0 represents APC (=OC0/OY0).

Below the income level OY0, consumption is more than income. In this range, APC > 1. Above the income level OY0, consumption increases less than proportionately with income so that APC declines and it is less than one.

#### Empirical Studies

Keynes put forth this hypothesis on the basis of “knowledge of human nature” ‘and “delailed facts of experience”. His followers in a number ofempirical studies based on cross-section budget figures and short-run time series data in the late 1930s and mid-1940s confirmed his hypothesis.

They found that families with higher income levels consumed more which confirms that MPC is greater than zero (c>0), but by less than the increase in income (c<1). They also found that families with higher income levels saved more and so consumed a smaller proportion of income which confirms that APC falls as income rises.

#### THE CONSUMPTION PUZZLE

Keynes’ assertion that the APC falls as income rises led some Keynesians to formulate the secular stagnation thesis around 1940. According to these economists, as incomes grew in the economy, households would save more and consume less. As a result, aggregate demand would fall short of output. If the government spending was not increased at a faster rate than income, the economy would lapse into stagnation. But after World War II, the American economy experienced inflation rather than stagnation even when the government expenditures were reduced below 1941 level in constant dollars. The Keynesian consumption function had been proved wrong. This was due to the conversion of government bonds into liquid assets after the War by the households in order to meet their pent up demand for consumer goods.

In 1946, Kuznets studied the consumption and income data for the United States during the period 1869-1938 and estimated the consumption function for this period as 0.9.1 Further, he arrived at two conclusions: one, over the long-run, on the average, the APC did not show any downward trend so that the MPC equalled the APC as income increased along a long- run trend. This means that the consumption function is astraight line through the origin, as shown by the CL line in Fig. 2, and two, the years in which the APC was below the long-run average were boom periods, and the years in which the APC was above the long-run average were of slump periods. This implies that in the short-run as income changes over the business cycle, the MPC is less than the APC, as shown by the Cs curve in Fig. 2

These findings were later verified by Goldsmith in 1955 who found the -run consumption function to be stable at 0.87.Thus these two studies revealed that for the short-run time series, the consumption function is non-proportional because APC >MPC and for the long-run time series, the consumption function is proportional, APC = MPC.

The failure of the secular stagnation hypothesis and the findings of Kuznets and Goldsmith were a puzzle to the economists which is known as the consumption puzzle. Figure 2 illustrates this puzzle where there are two consumption functions. Cs is the Keynesian consumption function which is non-proportionl (APC >MPC) and based on the short-run time series data. CL is the long-run proportional consumption function (APC = MPC) based on long-run time series data. Over the years, economists have been engaged in solving this puzzle by reconciling the two consumption functions.

#### Criticisms

The great merit of this theory is that it lays stress on factors other than in income which affect the consumer behaviour. In this sense, it represents a major advance in the theory of the consumption function. However, it has its shortcomings.

1. The theory does not tell the rate of upward drift along the CL curve. It appears to be a matter of chance.

2. It is just a coincidence if the factors explained above cause the consumption function to increase proportionately with increase in income so that the average of the values in the short-run consumption function equals a fixed proportion of income.

3. According to Duesenberry, all the factors mentioned as causes of the upward shift are not likely to have sufficient force to change the consumption-savings relationship to such an extent as to cause the drift.

4. Duesenberry also points out that many of the factors such as decline in saving motive would lead to a secular fall in the consumption function. Such saving plans as life insurance and pension programs tend to increase savings and decrease the consumption function. Moreover, people want more supplementary savings to meet post-retirement needs which tend to decrease their current consumption.