Chapter Four

Consumption and Investment Function

4.1 Consumption Function

4.1.1 John Maynard Keynes's General Theory

Keynes made the consumption function central to his theory of economic fluctuations, and it has
played a key role in macroeconomic analysis ever since. Let's consider what Keynes thought
about the consumption function, and then see what puzzles arose when his ideas were confronted
with the data.
Keynes's Conjectures
Today, economists who study consumption rely on sophisticated techniques of data analysis.
With the help of computers, they analyze aggregate data on the behavior of the overall economy
from the national income accounts and detailed data on the behavior of individual households
from surveys. Because Keynes wrote in the 1930s, however, he had neither the advantage of
these data nor the computers necessary to analyze such large data sets. Instead of relying on
statistical analysis, Keynes made conjectures about the consumption function based on
introspection and casual observation.

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First: Keynes conjectured that the marginal propensity to consume—the amount consumed out
of an additional unit of income—is between zero and one. He wrote that the "fundamental
psychological law, upon which we are entitled to depend with great confidence . . . is that men
are disposed, as a rule and on the average, to increase their consumption as their income
increases, but not by as much as the increase in their income.'' That is, when a person earns an
extra unit of income, he typically spends some of it and saves some of it.

Second, Keynes posited that the ratio of consumption to income, called the average propensity
to consume, falls as income rises. He believed that saving was a luxury, so he expected the rich
to save a higher proportion of their income than the poor.

Third, Keynes thought that income is the primary determinant of consumption and that the
interest rate does not have an important role. This conjecture stood in stark contrast to the
beliefs of the classical economists who preceded him. The Classical economists held that a
higher interest rate encourages saving and discourages consumption. Keynes admitted that the
interest rate could influence consumption as a matter of theory. Yet he wrote that "the main
conclusion suggested by experience, I think, is that the short-period influence of the rate of
interest on individual spending out of a given income is secondary and relatively unimportant.''

Figure 1.1

On the basis of these three conjectures, the Keynesian consumption function is often written as

C  cY where  0, 0 c 1,

where C is consumption, Y is disposable income, is a constant, and c is the marginal
propensity to consume. This consumption function, shown in Figure 1-1, is graphed as a
straight line.

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Notice that this consumption function exhibits the three properties that Keynes posited. 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. This
consumption function satisfies Keynes's second property because the average propensity to
consume APC is 

APC C/Y /Y c. 



As Y rises, /Y falls, and so the average propensity to consume C/Y falls. 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. 

4.1.2 Irving Fisher and Inter-temporal Choice
The consumption function introduced by Keynes relates current consumption to current income.
This relationship, however, is incomplete at best. When people decide how much to consume
and how much to save, they consider both the present and the future.

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 Inter-temporal Budget Constraint

Most people would prefer to increase the quantity or quality of the goods and services they
consume—to wear nicer clothes, eat at better restaurants, or see more movies. 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.
When they are deciding how much to consume today versus how much to save for the future,
they face an Intertemporal budget constraint, which measures the total resources available
for consumption today and in the future. Our first step in developing Fisher's model is to
examine this constraint in some detail.

To keep things simple, we examine the decision facing a consumer who lives for two periods.
Period one represents the consumer's youth, and period two represents the consumer's old age.
The consumer earns income Y1 and consumes C1 in period one, and earns income Y2 and
consumes C2 in period two. (All variables are real—that is, adjusted for inflation.) Because
the consumer has the opportunity to borrow and save, consumption in any single period can be
either greater or less than income in that period.

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Consider how the consumer's income in the two periods constrains consumption in the
two periods. In the first period, saving equals income minus consumption. That is,

S Y1 C1,

where S is saving. In the second period, consumption equals the accumulated saving,
including the interest earned on that saving, plus second-period income. That is,

C2 (1 r)S Y2,

where r is the real interest rate.

For example, if the interest rate is 5 percent, then for every $1 of saving in period one, the
consumer enjoys an extra $1.05 of consumption in period two. Because there is no third period,
the consumer does not save in the second period.

Note that the variable S can represent either saving or borrowing and that these equations
hold in both cases.
 If first-period consumption is less than first period income (C1<Y1), the consumer is
saving, and S is greater than zero.
 If first-period consumption exceeds first-period income(C1>Y1), the consumer is
borrowing, and S is less than zero. For simplicity, we assume that the interest rate for
borrowing is the same as the interest rate for saving.

To derive the consumer's budget constraint, combine the two preceding equations. Substitute the
first equation for S into the second equation to obtain

C2 (1 r)(Y1 C1) Y2.

To make the equation easier to interpret, we must rearrange terms. To place all the consumption
terms together, bring (1 r)C1 from the right-hand side to the left-hand side of the equation to
obtain

(1 r)C1 C2 (1 r)Y1 Y2.

Now divide both sides by 1 r to obtain

C1  Y 1

This equation relates consumption in the two periods to income in the two periods. It is the
standard way of expressing the consumer's intertemporal budget constraint.

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4.1.3 Franco Modigliani and the Life-Cycle Hypothesis
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 it is low. This interpretation of consumer behavior formed the basis for his life-cycle

hypothesis.
The Hypothesis
One important reason that income varies over a person's life is retirement. Most people plan to
stop working at about age 65, and they expect their incomes to fall when they retire. Yet they do
not want a large drop in their standard of living, as measured by their consumption. To maintain
consumption after retirement, people must save during their working years. Let's see what this
motive for saving implies for the consumption function.

Consider a consumer who expects to live another T years, has wealth of W, and expects to earn
income Y until he/she retires R years from now. What level of consumption will the consumer
choose if he/she wishes to maintain a smooth level of consumption over his/her life?

The consumer's lifetime resources are composed of initial wealth W and lifetime earnings of R
Y. (For simplicity, we are assuming an interest rate of zero; if the interest rate were greater than
zero, we would need to take account of interest earned on savings as well.) The consumer can
divide up his/her lifetime resources among her T remaining years of life. We assume that He/she
wishes to achieve the smoothest possible path of consumption over his/ her lifetime. Therefore,
he/she divides this total of W RY equally among the T years and each year consumes
C (W RY )/T.
We can write this person's consumption function as
C (1/T )W (R/T )Y.
For example, if the consumer expects to live for 50 more years and work for 30 of them, then T
50 and R 30, so his/ her consumption function is
C 0.02W 0.6Y.
This equation says that consumption depends on both income and wealth. An extra $1 of income
per year raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by

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$0.02 per year.
If every individual in the economy plans consumption like this, then the aggregate consumption
function is much the same as the individual one. In particular, aggregate consumption depends
on both wealth and income. That is, the economy's consumption function is
CWY,
Where the parameter  is the marginal propensity to consume out of wealth, and  is the
marginal propensity to consume out of income the parameter.
Figure 1.10

4.1.4 Milton Friedman and the Permanent-Income Hypothesis

In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to
explain consumer behavior. Friedman's permanent income hypothesis complements
Modigliani's life-cycle hypothesis: both use Irving Fisher's theory of the consumer to argue
that consumption should not depend on current income alone. But unlike the life-cycle
hypothesis, which emphasizes that income follows a regular pattern over a person's
lifetime, the permanent-income hypothesis emphasizes that people experience random and
temporary changes in their incomes from year to year.
The Hypothesis
Friedman suggested that we view current income Y as the sum of two components, permanent
income Y P and transitory income Y T.That is,
Y Y P Y T.

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Permanent income is the part of income that people expect to persist into the future.
Transitory income is the part of income that people do not expect to persist.
Put differently, permanent income is average income, and transitory income is the random
deviation from that average.
To see how we might separate income into these two parts, consider these examples:

 Haftom, who has a law degree, earned more this year than yohannes, who is a high-
school dropout. Haftom's higher income resulted from higher permanent income, because
his education will continue to provide him a higher salary.
 Kasim, a Harar orange grower, earned less than usual this year because a freeze destroyed
his crop. Ali, an awash orange grower, earned more than usual because the freeze in
Harar drove up the price of oranges. Ali's higher income resulted from higher transitory
income, because he is no more likely than Kasim to have good weather next year.
These examples show that different forms of income have different degrees of persistence. A
good education provides a permanently higher income, whereas good weather provides only
transitorily higher income. Although one can imagine intermediate cases, it is useful to keep
things simple by supposing that there are only two kinds of income: permanent and transitory.
Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption in response to transitory changes in
income.
For example, if a person received a permanent raise of $10,000 per year, his consumption would
rise by about as much. Yet if a person won $10,000 in a lottery, he would not consume it all in
one year. Instead, he would spread the extra consumption over the rest of his life. Assuming an
interest rate of zero and a remaining life span of 50 years, consumption would rise by only $200
per year in response to the $10,000 prize. Thus, consumers spend their permanent income, but
they save rather than spend most of their transitory income.
Friedman concluded that we should view the consumption function as approximately
CY P,

where is a constant that measures the fraction of permanent income consumed. The
permanent-income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income.

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4.1.5 Robert Hall and the Random-Walk Hypothesis
The permanent-income hypothesis is based on Fisher's model of intertemporal choice. It builds
on the idea that forward-looking consumers base their consumption decisions not only on
their current income but also on the income they expect to receive in the future. Thus,
the permanent-income hypothesis highlights that consumption depends on people's expectations.
Recent research on consumption has combined this view of the consumer with the
assumption of rational expectations. The rational-expectations assumption states that people
use all available information to make optimal forecasts about the future. This assumption can
have profound implications for the costs of stopping inflation. It can also have profound
implications for the study of consumer behavior.
The Hypothesis
The economist Robert Hall was the first to derive the implications of rational expectations for
consumption. He showed that if the permanent-income hypothesis is correct and if consumers
have rational expectations, then changes in consumption over time should be unpredictable.
When changes in a variable are unpredictable, the variable is said to follow a random walk.
According to Hall, the combination of the permanent-income hypothesis and rational
expectations implies that consumption follows a random walk.

Hall reasoned as follows. According to the permanent-income hypothesis, consumers face

fluctuating income and try their best to smooth their consumption over time. At any moment,
consumers choose consumption based on their current expectations of their lifetime incomes.
Over time, they change their consumption because they receive news that causes them to
revise their expectations.
For example, a person getting an unexpected promotion increases consumption, whereas a
person getting an unexpected demotion decreases consumption. In other words, changes in
consumption reflect "surprises" about life-time income. If consumers are optimally using all
available information, then they should be surprised only by events that were entirely
unpredictable. Therefore, changes in their consumption should be unpredictable as well.

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