Macro Economics: Keynesian consumption function, Kuznets' paradox, Duesenberry Relative Income hypothesis

1. Theories of the Consumption
Function - I
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Prof. Prabha Panth
Osmania University,
Hyderabad

2. Keynesian Consumption Function
1. Absolute Income Hypothesis: Keynes’
consumption function based on Psychological
Law.
• Not based on empirical data.
• Short run analysis.
• Y  C , but < Y .
• C = a + bY, where a is autonomous C, and b is
MPC.
• According to Keynes, MPC is constant.
• But APC falls as Y increases.
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3. C, S
Y
C=a+bY
MPC = slope of C-
function. Is constant
Y=C+S
0
APC =slope of radius
vector. Falls as Y
increases
Keynesian Consumption Function
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4. Empirical Consumption Function
• Keynes assumed that:
– Current absolute C is related to current Y.
– C-Y relationship is reversible – consumers will
increase C when Y increases, and decrease
C when Y decreases.
– Consumer’s C-patterns are determined
autonomously. That is, consumers’ C is
independent of other’s C.
– APC as Y, and
– MPC remains constant as Y.
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5. Kuznet’s Paradox
• Empirical data does not entirely support
Keynes’ C-function.
• Simon Kuznets: showed that behaviour of
APC and MPC were not the same for the
short run,
• and long run consumption functions,
• And for cross section and time series data.
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6. • Kuznets’ empirical analysis:
– Time series data showed APC is constant for
the long run (1889-1938 USA data), around
0.8.
– Therefore MPC = APC.
– But for Cross section data, or short run,
APC falls and APS increases, as Y increases,
• This is called Kuznet’s Paradox.
• Different economists tried to explain this
empirical puzzle,
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7. II. Relative Income Hypothesis
• J.S. Duesenberry’s theory of Relative
Income.
– Consumption is relative to other’s C, as well
as to relative Y.
– Depends on a person’s position in society,
compared to others.
– C is irreversible over time, as Y C will not fall
at the same rate.
– Consumers want to maintain their old
standard of living
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8. C = a + bYt + bYt-1
According to Duesenberry (cross section
data):
• If one person’s Y, and Ys of all others
also increase at the same rate, then C –
function shifts upwards.
• Relative position will not change and there
will be no change in consumers’ C/Y.
• This means APC and APS remain
constant.
• Supports Kuznet’s findings of empirical
analysis.
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9. C, S
Y
0
Y=C+S
C1
A B
A1
B1 C2
DUESENBERRY’S
RELATIVE INCOME
HYPOTHESIS
When Y and C of both
A and B increases at
the same rate, then
C-function shifts
upwards, and APC of
both remain constant.
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10. • But if a consumer’s Y increases > others,
then his APC more than others.
• Relative income hypothesis suggests that
HH try to imitate the C of their neighbours.
• This is called the “Duesenberry effect” or
the “demonstration effect.”
• He also suggested that C levels are
irreversible downwards.
• When Y, C will not fall at the same rate.
So APC, when Y
• This is called the “Ratchet effect”
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11. C, S
0
Y
C
Y1
C1
Y0
C0
When Y falls to Y0, C also falls,
but APC increases.
This is the Ratchet Effect.
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