Lesson 39
CONSUMPTION THEORIES (CONTINUED)
SUMMARIZATION:
JOHN MAYNARD KEYNES AND THE CONSUMPTION FUNCTION
The consumption function exhibits three properties that Keynes conjectured.
x The marginal propensity to consume c is between zero and one.
x The average propensity to consume falls as income rises.
x Consumption is determined by current income.
SIMON KUZNETS AND THE CONSUMPTION PUZZLE
x The failure of the secular-stagnation hypothesis and the findings of Kuznets both
indicated that the average propensity to consume is fairly constant over time.
x This presented a puzzle: why did Keynes’ conjectures hold up well in the studies of
household data and in the studies of short time-series, but fail when long time series
were examined?
IRVING FISHER AND INTERTEMPORAL CHOICE
The economist Irving Fisher developed the model with which economists analyze how rational,
forward-looking consumers make intertemporal choices-- that is, choices involving different
periods of time.
The model illuminates
x The constraints consumers face,
x The preferences they have, and
x How these constraints and preferences together determine their choices about
consumption and saving.
When consumers are deciding how much to consume today versus how much to consume in
the future, they face an intertemporal budget constraint, which measures the total resources
available for consumption today and in the future.
FRANCO MODIGLIANI AND THE LIFE-CYCLE HYPOTHESIS
In the 1950’s, Franco Modigliani, Ando and Brumberg used Fisher’s model of consumer
behavior to study the consumption function. One of their goals was to study the consumption
puzzle. According to Fisher’s model, consumption depends on a person’s lifetime income.
Modigliani emphasized that income 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 income is low. This interpretation of consumer behavior formed the basis of his life-
cycle hypothesis.
THE HYPOTHESIS
Most people plan to stop working at about age 65, and they expect their incomes to fall when
they retire, but don’t want a drop in standard of living characterized by consumption. Suppose
a consumer expects to live another T years, has wealth of W and expects to earn income Y
until she retires R years from now.
What level of consumption will the consumer choose to have a smooth consumption over her
life?
THE LIFE-CYCLE CONSUMPTION FUNCTION
The Lifetime resources of consumer for T years are wealth W and lifetime earnings of R x Y
(assuming interest rate to be zero). To have smoothest consumption over lifetime, she divides
such that:
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