INTRODUCTION

Consumption is the economic term for people spending money on goods and
services. Normal people are referred to as households in economics. Keyes rose
to the challenge and created the Keynesian ConsumptionFunction to model how
people spend theirmoney, and what happens to Consumption when Income
increases. In 1946 Simon Kuznets published a study of consumption and saving
behavior dating back to the civil war. Form his study he estimated that APC was
near 0.9 in the period 1869 – 1933 into three overlapping of 30 years. He found
that ratio of consumption and income was nearly same and equal to about 0.87 in
all the three sub period.

Keynes’s Theory of Consumption

The concept of consumption function plays an important role in Keynes’ theory of

income and employment. According to Keynes, of all the factors it is the current
level of income that determines the consumption of an individual and also of
society. Keynes laid stress on the absolute size of current income as a
determinant of consumption, for which his theory of consumption is also known
as absolute income theory of consumption. The Keynes’ consumption function
can be expressed in the following form:

C = a + bYd
Where C = consumption expenditure

Yd = The real income

a = The constant parameter which reflects autonomous consumption, i.e.

the amount of consumption expenditure at zero level of income

b= The constant parameter which reflects the marginal propensity to

consume (MPC) which measures the increase in consumption spending in

response to per unit increase in disposable income. Mathematically:

b = MPC = ∆C/∆Y
The Keynesian concept of consumption function stems from the fundamental
psychological law of consumption which states that there is a common tendency
for people to spend more on consumption when income increases, but not to the
same extent as the rise in income because a part of the income is also saved. The
fundamental psychological law of consumption is based on three propositions
with respect to consumption behaviour.

1. When the total income increases, the consumption expenditure of the

community will also increase, but less proportionately. In economic terms, this
means that Marginal Propensity to Consume is less than one but greater than
Zero (i.e 1> MPC>0).

2. An increment of income will be divided in some ratio between saving and

consumption.

3. An increase in income will, thus, lead to an increase in both consumption and

savings.
NOTE : the MPC is the slope of
the consumption function,
APC= C/Y
Fig 1 - Keynes’s
consumption function
(form Wikipedia)

Kuznets consumption
Puzzle
In Kuznets consumption
function no intersect part i.e. autonomous consumption is 0.
Because in long run it is said to be impossible that there is a
consumption when income is zero.

That wise the function is -

C = b Yd
 In Keynes consumption function APC falls as income rises but in
Kuznets consumption function it remains constant over a long period. The value
of MPC which is less then 1 is much higher in Kuznet’s function as compare to that
of Keynes.

Fig 2 , Kuznet’s consumption function (form Wikipedia)

 THE CONSUMPTION PUZZLE

Studies of household data and short time series found a relationship between
consumption and income similar to the one KEYNES conjectured. In the fig 2 this
relation is called the short-run consumption function But studies of long time-
series found that the APC did not vary systematically with income. This relation is
called the long-run consumption function. Notice that the short-run consumption
function has a falling average propensity to consume, whereas the long-run
consumption function has a constant average propensity to consume. That’s why
its call puzzle.
 Solution of consumption Puzzle
The problem of consumption puzzle can be solved by neoclassical economist by
the following model –

 Constraint on borrowing in consumption by FISHER’s intertemporal choice

In this model we assumed that consumer can borrow as well as save. The
ability to borrow allows current consumption to exceed current income.
Rational individuals always prefer to increase the quantity or quality of the
goods and services they consume. However, most people cannot consume
as much as they like due to limited income called budget constraint. For the
sake of simplicity let us assume that our representative consumer lives for
two periods:
Period-1 represents consumer’s youth life
Period -2 represents consumer’s old age. Consumer’s income
and consumption in the two periods are Y1, and C1 and Y2 and C2,
respectively. In the first period, saving (S) is the difference between income
and consumption which is expressed as:

S = Y 1 – C1 … (1)

In the second period consumption equals the accumulated saving (which

includes the interest(r) earned on that saving), plus second-period income
which is expressed as:

C2 = (1 + r)S + Y2 … (2)
Where; r = real interest rate (i.e., nominal interest adjusted for inflation).
Since we do not consider the third period, the consumer is not required to save in
the second period.

We can now derive the consumer’s budget constraint by combining equations (1)
and (2). If we substitute the first equation for S into the second equation we get

C 2 = (1 + r) (Y1 – C1) + Y2
or, (1 + r) C 1 + C2 = (1 + r)Y1 + Y2
 C1 + C2/(1+r) = Y1 + Y2/(1+r)

Fig-3 Constraint on borrowing ( form Wikipedia)

 Life cycle Hypothesis

Franco Modigliani and his collaborate they emphasis life cycle hypothesis model,
according to fishers model conjunction depends on person's lifetime income but
in this model that income varies systematically over people life's and that savings
allows consumer to move income form those time in life when income is high to
those time it is low. This interpretation of consumer behavior formed the base for
the LCH.

In this model itch year consumption is given by –

W + RY
C= T

Where W = wealth ; T = expects to life ; Y = income ; R = incoming years.

 Relative income hypothesis

Relative income hypothesis states that the satisfaction (or utility) an individual
derives from a given consumption level depends on its relative magnitude in the
society rather than its absolute level. It is based on a postulate that has long been
acknowledged by psychologists and sociologists, namely that individuals care
about status. In economics, relative income hypothesis is attributed to James
Duesenberry. At the time when Duesenberry wrote his book the dominant theory
of consumption was the one developed by the English economist John Maynard
Keynes, which was based on the hypothesis that individuals consume a
decreasing, and save an increasing, percentage of their income as their income
increases. This was indeed the pattern observed in cross-sectional consumption
data: At a given point in time the rich in the population saved a higher fraction of
their income than the poor did. However, Keynesian theory was contradicted by
another empirical regularity: Aggregate saving rate did not grow over time as
aggregate income grew. Duesenberry argued that relative income hypothesis
could account for both the cross-sectional and time series evidence. Duesenberry
claimed that an individual’s utility index depended on the ratio of his or her
consumption to a weighted average of the consumption of the others. From this
he drew two conclusions: (1) aggregate saving rate is independent of aggregate
income, which is consistent with the time series evidence; and (2) the propensity
to save of an individual is an increasing function of his or her percentile position in
the income distribution, which is consistent with the cross-sectional evidence.

References
 Macroeconomic theory and policy : William H Branson

 Macroeconomics : N Gregory Mankiw

  Wikipedia

I would like to express my special thanks of gratitude to my teacher

Dr Santanu Chakraborty, Dr Probir Karar and Sir Manabesh Mzumdar who
gave me the golden opportunity to do this project on the topic
CONSUMPTION PUZZEL . It helped me in doing a lot of Research and I
came to know about a lot of things related to this topic.
Finally, I would also like to thank my parents and friends who helped me
a lot in finalizing this project within the limited time frame.
____________________ ____________________

DATE : Signature of student :

__________________________

Signature of teacher: