Page 101 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes 5.2.2 Relative Income Hypothesis

One of the earliest attempts to derive a theory of consumption on the basis of new empirical
evidence in the 1940s was James Duesenberry's theory known as relative income hypothesis.
This hypothesis comprises two parts: the first part does not assume that a household's
consumption is a function of its absolute income. Instead, the household's position in the income
distribution of all households is considered to determine the relative income of the household.
Duesenberry maintains that if a household's relative income remains constant as its income
increases, then it will continue to spend the same proportion of its additional income on
consumption that it did prior to the increase. In other words, the household's APC remains
constant.

!
Caution The relative income hypothesis focuses on the imitative or emulative nature of
consumption. Households tend to emulate the consumption standards of their rich
neighbours although their own incomes do not, in fact, permit these standards. This is
what Duesenberry calls the "demonstration effect". This means that, in effect, the
consumption of a household in a locality is determined not so much by its own income as
by the income of its richest neighbours.
The second part of the relative income hypothesis is used to explain the non-proportionality
over the course of a business cycle. Duesenberry holds that it is much easier for households to
adjust to rising incomes than to falling incomes. As the household's absolute income rises, its
standard of living also rises and this higher standard soon becomes the "expected" standard of
living. Thus, as a household's income begins to decline in a recession, its attempt to maintain
this standard of living results in a less rapid decline in consumption than income.
Because consumption does not decline in proportion to the decline in national income, the
aggregate consumption function observed over a period of falling income will have a smaller
MPC than the MPC of a consumption function that has a continuously rising income.

!

Caution This notion was corroborated by the empirical data according to which the MPC
in the US during the Great Depression of 1929-33 was approximately 0.77 while the MPC
of the long run aggregate consumption function derived from Kurnet's data was about
0.89. The relative income hypothesis states that this difference between the long run MPC
and the short run MPC results from the fact that the peak disposable income of 1929 was
not surpassed until 1939.
This phenomenon in Duesenberry's theory is referred to as the "ratchet effect". Ratchet is a
mechanical device consisting of a set of teeth on a base or a wheel allowing motion in one
direction only, for example, pre-wheel of a bicycle. This effect is illustrated in Figure 5.6.

The long run consumption function 'C ' is drawn as a ray from the origin, meaning that
ir
consumption is proportional to disposable income and therefore APC=MPC. Suppose that a
recession hits the economy at income Y and that the disposable income falls to Y and that due
d1 d0
to the ratchet effect, consumption does not fall back, but instead falls back along the short run
1
consumption function C . Consumption well therefore be C rather than Co. MPC be lower.
sr 0
As the economy recovers from the recession and disposable income begins to rise again,
consumption rises along C until the previous peak level of disposable income, Y , is reached.
sr dl
At this point consumption once again moves along C .
ir

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