Page 100 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 5: Consumption Function

Short run analysis based on family budget studies covering a large sample or cross-section of Notes
households conclude that
Savings tend to be negative at low levels of income,

The APC decreases as income increases, and
The MPC probably decreases as income increases, although the decline may be relatively
slight depending on other factors, especially the distribution of income among households.
This suggests that the short run consumption function of the economy is best represented
by equation 2 yielding a consumption curve with a vertical intercept and a slope (i.e., b)
º
less than that of the 45 diagonal. This means that in a short period, say a year, the APC
tends to be greater than the MPC.
On the contrary, long run studies based on historical or time-series data covering many years
have concluded that both the APC and MPC tend to remain constant and equal as income rises.
This suggests that in the long run consumption function, the autonomous consumption tends to
disappear and all the consumption turns out to be induced consumption. Thus in the long run
C=b.Y. The consumption curve representing long run income consumption relationships in the
º
economy tends to be a range from the origin and runs close to the 45 diagonal (Figure 5.5).
Figure 5.5

5.2.1 Absolute Income Hypothesis

Keynes and his early followers placed primary emphasis on the influence of a household's
absolute level of income on its consumption. Keynes assumed that the consumption expenditure
of an individual or a household depended solely on the absolute level of his income. The
resulting theory of consumption later become known as the absolute income hypothesis, named
because the theory explicitly assumes that consumption is the function of either a household's or
a nation's absolute income.
The consumption function is based on the assumption that the absolute income hypothesis is
linear; the MPC is therefore constant but less than the APC, because the intercept is a positive
term and the APC diminishes as disposable income increases. This is the essence of the absolute
income hypothesis.
The post-Keynesian studies on consumption function have attempted to distinguish between
the short run consumption function and long run consumption function and found that most of
the postulates of Keynes consumption function hold good in the short run only and not in the
long run.

LOVELY PROFESSIONAL UNIVERSITY 95