Economics
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Definition[]

  • Consumption is the destruction of want satisfying capacity (Micro definition)
  • The part of income which is not saved (Macro definition)

Consumption under Certainty - The Permanent Income Hypothesis[]

The Permanent Income Hypothesis[]

According to the permanent income hypothesis as formulated by Milton Friedman an individual's consumption in a given period is not determined by income in that period, but by the individual's life time income and initial wealth, permanent income. Temporary changes in income, transitory income, will therefore not have an effect on income unless they change permanent income significantly.

In Friedman's model individuals are maximizing utility and can save and borrow at an exogenous interest rate. The only restriction is that all debt is repayed at the end of his or her life.


The permanent income function implies that savings are essentially future consumption.

The Life Cycle Hypothesis[]

Developed by Modigliani and Brumberg (1954, 1979), the life cycle hypothesis is similar to the Friedman's permanent income, though there are important, subtle differences. The life cycle hypothesis considers a finitely-lived individual, and takes into account such factors as age, consumption, savings, and the accumulation of assets. This contrasts with permanent income, which is concerned with an infinitely-lived individual, and is more focused on the short-term changes in consumption (but still assuming lifetime smoothing).

Consumption under Uncertainty[]

Robert Hall showed in his 1978 contribution to the Journal of Political Economy, "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis:Theory and Evidence., that consumption essentially follows a random walk if rational expectations are assumed. This implies that individuals adjust current consumption to the point where it is equal to expected future consumption. Changes in current consumption are furthermore determined by changes in expected lifetime income divided by the number of periods of life remaining.

Responses to Changes in Interest Rate[]

If Friedman's model of consumption under certainty is expanded to account for interest rate changes, consumption doesn't necessarily follow a random walk. Specifically, consumption rises over time if the interest rate exceeds the discount rate and vice versa. Rising interest rates do however not only imply that future consumption rises at the expense of current consumption through savings. The effect of an interest rate change on consumption can be split up into a substituion effect from current consumption to future consumption, and into an income effect of higher future consumption on the basis of constant savings.

Ru-C1d

The interest rate change has a positive impact on both current and future consumption.

Ru-Cd

The interest rate change has a negative impact on both current and future consumption.

Ru-C2u

The interest rate change has no substituion effect, but an income effect on future consumption.

Consumption in Keynes[]

The traditional Keynesian consumption function posits that consumption is determined by current disposable income. This relationship is furthermore assumed to be fairly stable over time.

Empirical Evidence[]

Keynes's claim that consumption is determined by current income can only be observed empirically at a point in time accross households. Over time though, within a country the relationship doesn't hold and consumption shows a proportionate relationship to income.

Campbell and Mankiw, as well as Shea and many others found that empirically the null hypothesis of no effect of transitory income changes on consumption can be strongly rejected. However these results were estimated only for small cyclical variations in income, which are less obviously predictable. Paxson, Browning and Collado, and Hsieh considered precitable income movements of as much as 10 percent or more of a family's annual income and found that the permanent income hypothesis describes consumption behavior well.

References[]

  1. Friedman, Milton. 1957. A Theory of the Consumption Function. Princeton, NJ:Princeton University Press
  1. Hall, Robert. 1978.. "Stochastic Implications of the LIfe Cycle-Permanent Income Hypothesis:Theory and Evidence." Journal of Political Economy
  1. Romer, David. 2005. Advanced Macroeconomics. McGraw-Hill, Irwin. 3rd edition
  1. Romer, see above
This macro-stub needs improving.

Consumption CAPM/Risky assets needs to be added

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