(UNIT 1).

Theories of Consumption and investment

John Maynard Keynes’s Conjectures

Keynes presented three critical statements over the consumption behavior of a consumer in the
context of the fluctuation in the income which he stated as the primary determinant of the
consumption and saving.
 Marginal propensity to consume (MPC): the amount consumed out of the additional penny of
income lies between 0 to 1.
In simpler words with increase in an income of consumer, s/he also increases the
consumption but not with same rate of increase in the income. S/he tries to save some part
of the increased income.
Fun: C = C− + cY, C− > 0, 0 < c < 1

C is consumption, Y is disposable income, C− is a constant, and c is the marginal propensity

to consume.

 Average propensity to consume (APC): It is the ratio of consumption to income which

generally falls as income increases.

 Role of income and interest rate in consumption function: Stating the income as the primary
determinant whereas, interest rate isn’t as such influencer of the consumption function
because interest rate wasn’t influencing factor on individual spending of a given income over
a short period of time.

Graph and Explanation

This consumption function shows the graphed as a straight line. C− determines the intercept
on the vertical axis and c determines the slope.

1. It satisfies Keynes’s first property because the marginal propensity to consume c is between
zero and one, so that higher income leads to higher consumption and also to higher saving.

2. This consumption function satisfies Keynes’s second property because the average propensity
to consume APC is APC = C/Y = C−/Y + c. As Y rises, C−/Y falls, and so the average
propensity to consume C/Y falls.

3. And finally, this consumption function satisfies Keynes’s third property because the Interest
rate is not included in this equation as a determinant of consumption.

The proposed conjectures made researchers to collect and examine data to test his
authenticity. Through the data they found the good approximation of the theory as

1. Researchers examined aggregate data on consumption and income for the period between the
two world wars. In years when income was unusually low, such as during the depths of the
Great Depression, both consumption and saving were low, indicating that the marginal
propensity to consume is between zero and one.

2. In addition, during those years of low income, the ratio of consumption to income was high,
confirming second conjecture.

3. Finally, because the correlation between income and consumption was so strong, no other
variable appeared to be important for explaining consumption. Thus, the data also confirmed
third conjecture that income is the primary determinant of how much people choose to
consume.

Thus, these data verified Keynes’s conjectures about the marginal and average propensities to
consume.

Secular Stagnation, Simon Kuznets and the Consumption Puzzle.

But much later, some abnormalities of the conjectures discarded the theory and again puzzled the
consumption behavior.

Some economists reexamined and predicted during the World War 2

 On the basis of the Keynesian consumption function, these economists reasoned that as
incomes in the economy grew over time, households would consume a smaller and smaller
fraction of their incomes. They feared that there might not be enough profitable investment
projects to absorb all this saving. If so, the low consumption would lead to an inadequate
demand for goods and services, resulting in a depression. In other words. Economists
predicted that the economy would experience what they called secular stagnation—a long
depression of indefinite duration—unless the government used fiscal policy to expand
aggregate demand. The end of World War II did not throw the country into another depression.
Although incomes were much higher after the war than before, these higher incomes did not
lead to large increases in the rate of saving.
  Economist Simon Kuznets constructed new aggregate data on consumption and income
dating back to 1869. He discovered that the ratio of consumption to income was remarkably
stable from decade to decade, despite large increases in income over the period he studied.
The failure of the secular-stagnation hypothesis and the findings of Kuznets both indicated that
the average propensity to consume is fairly constant over long periods of time.

Why did Keynes’s 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?

The study suggested that there were two consumption functions. For the household data and for the
short time-series, the Keynesian consumption function appeared to work well. Yet for the long time-
series, the consumption function appeared to exhibit a constant average propensity to consume.

In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of these seemingly
contradictory findings. Both Modigliani’s life-cycle hypothesis and Friedman’s permanent-income
hypothesis rely on the theory of consumer behavior proposed much earlier by Irving Fisher.
Intertemporal choice.
Intertemporal choice

According to the Keynes consumption hypothesis, consumer’s current consumption depend upon the
current income. But relatively it is not true because during consumption and saving from an income,
consumer decides how to consume and how to save with consideration of present as well as future.
The more income is consumed today’s satisfaction, the less they will be able to consume for future
and furthermore trade off.

Fisher’s model illuminates the constraints consumers face, the preferences they have, and how these
constraints and preferences together determine their choices about consumption and saving.

Intertemporal budget constraints

It measures the total resources available for consumption today and in the future.
The reason people consume less than they desire is that their consumption is constrained by their
income. In other words, consumers face a limit on how much they can spend, called a budget
constraint.

Considering consumer rational, we assume the Y1 ≠ C1 and Y2 ≠ C2.

Now, if supposing, consumer saves some port of Y1 in period 1 for future, then this means

Since Keynes conjectures are discarded due to consumer being rational and in reality. Therefore rate
of interest

(r>0 or r<0) but r≠0

Now savings made for the future consumption that is period 2 will be

i.e.

In the period 2 consumption

(C2) = saving (S) including the interest earned (1+r) on that saving +income (Y2)

Of the second period. Thus the enjoying the whole consumption in period 2 if saving is made in
period 1.

Also
, s>0, Y1>C1 then saver

s<0, Y1<C1 then borrower

Deriving budget constraint

Taking the given equations

S = Y1 - C1 -----eqn 1

C2 = (1+r) S + Y2 -----eqn 2

On computation

Now divide both sides by (1 + r) to obtain

Thus this is intertemporal budget constraint.

The Factor 1/ (1 + r) is the discounting factor*.

*Discounting factor measures the how much consumption in period 1 needs to be sacrificed in order
to consumer 1 unit in period 2 .The use of discounting factor is important because it
illustrates an real economic life fact that income in the future will be less valuable than
today.

If r = 0, then C1 + C2 = Y1 + Y2, but in reality r≠0

Also, If C1 > Y1, then consumer might have borrowed for more consumption in period 1 and have to
payback along with interest in period 2. Therefore the consumer has to payback Y2/ (1+r) in the
period 2

Graph and explanation (Handwritten)