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John M. Keynes: Absolute Income Hypothesis

John M. Keynes: Absolute Income Hypothesis

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Properties of Consumption Function
Consumption is determined by current income
Marginal propensity to consume (MPC = ΔC/ΔY) is
between zero and one (0Average propensity to consume (APC = C/Y) falls as
income rises

Short-run Consumption Function
Consumption expenditure

C = C + cY
Constant APC

c
C
Disposable income

Empirical Evidence
High income families have a higher marginal propensity
to save (MPS = 1 – MPC)
High income families have a higher average propensity to
save (APS = 1 – APC); APC falls with the level of income
In the long-run, autonomous consumption falls to zero
(C = 0)

Long-run Consumption Function
Consumption expenditure

C = ćY
Variable APC;
Ĉ=0

ć
Ĉ
Disposable income

Irving Fisher: Intertemporal Choice
Consumption decisions are based on current and future
income
Current period income = current income plus present
value of future income: Y1 + Y2 / (1 + r), where r is a
discount rate
Future period income = future income plus future value
of current income: Y2 + (1 + r)Y1

The Intertemporal Budget Line
Future Period
B
C2
A

Y2
C2
C1

Y1

C1

C
Current Period

The Intertemporal Budget Line
Along BC, there is a trade-off between current and
future consumption spending
Along AB, C1Y2: consumers would save in
current period to finance consumption in second period
Along AC, C1>Y1, but C2current period and will pay off debt in future period

Consumer Preferences
Consumer preferences are shown by a family of
indifference curves
Any combination of current and future consumption
along an indifference curve provides the same level of
satisfaction for the consumer
A higher indifference curve yields combinations with
greater satisfaction

Consumer Preferences
Future Period

Combination B is preferred to
combination A because it yields
more in both periods

B
A

Current Period

The Consumer’s Optimum
Consumer equilibrium is achieved at the tangency of
the highest attainable indifference curve and the
budget line
The tangency determines the optimum allocation of
consumption spending in both periods; i.e. highest
level of satisfaction within the budget

The Consumer’s Optimum
Future Period
Higher income shifts the budget
line up, positioning the consumer
on a higher indifference curve and
consumer’s optimum
C2f
C1f

B
A

C1c

C2c

Current Period