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Unlike investment spending, consumption spending tends to be orderly, rising and falling primarily in response to disposable income. It is less likely to initiate fluctuations in output. As a rule , movements in investment or in government or foreign spending alter income levels and induce (the multiplier) related movements in consumption. The consumption sector is not entirely passive. However , some types of expenditures , such as those for consumers durables or luxiuriesi hift in response to nonincomes forces , such as inflationary expectations,consumer credit, and changes in interest rates. For instance, a percipitious drop in outomobile sales , reacting to such pressures , was a key factor causing output to decline in 1980s in the U.S.A. and west Europe.
Since consumption purchases bulk large in the total GNP, even small fluctuations can be significant. Cyclical movements are especially important in some large industries supplying consumers goods and services , such as automobiles , airlines , travel, and recreation. Knowledge of the factors governing consumption plays a large role in the analysis of the long-run and short-run effects of changing fiscal policies. Alternations in tax rates can influence consumption spending by affecting disposal income. When taxes are raised, reduced income will lead to less spending , but the amount and timing of changes in spending and saving can be particularly important.
The elementary theory of the consumption function is so well known. Is is easy to forget what the nature of the original Keynesian rationale was. It was simply that a consumer’s expenditure in real terms is a function of his real personal disposable income. Both the marginal propensity to consume and the income elasticity of demand are positive but less than unity. Most currents interest in the consumption function concerns much more complex relations of aggregate consumer’s behavior. These refinements involve the shape of the function, the exclusion of short-run fluctions in income, the inclusion of wealth variables, distinctions between sources of income and categories of expenditure and the development of lag structures.
The dependence of consumption on income was, as we have seen a fundamental proposition of the “General Theory”. The precise from of this dependence has, however, been the subject of protracted (and continuing) debate. Keynes’s fundamental psychological law implied that the marginal propensity to consume was higher than the average propensity to consume , but less than one. Despite the many qualifications which Keynes mentioned, most Keynesian writers initially adopted some simple version of this relationship. These simple models soon run into trouble. First, the collection of national account data and of family budget data suggested that the consumption-income relationship differed according as it was taken to apply to long-run changes, to short-run changes or to cross section differences in family in family incomes.
Early national income studies suggested that there had been considered stability in the average propensity to consume over the long run, if cycling changes were ignored.
Cycling changes could probably be explained in terms of lags in the adjustement to changes in income, as Keynes had suggested. Far more difficult was the reconciliation of this apparen long-runconstany of the saving ratio with the observation of savings ratio which rose sharply with income cross-section analysis, and a number of hypothesis were advanced which attempted such reconcilition.
Secondly , it is noted that the simple consumption theories were no more than rough descriptions of observed behavior, and lacked a solid theoretical foundation. In particular, it became evident that once the role of saving in increasing wealth was recognized, the theory of consumption would have to allow for interrelations among consumption, income and wealth, rather than simply between consumption and incomes.
Of post-war attempts to re-specify the consumption function so as to explain on the one both cross-section and time-series behavior, and on the other hand both short-run and long-run changes in the relation between consumption and income, the “permanent income hypohesis” intruduced by Friedman and the “Life –Cycle Hypothesis” introduced by Modigliant and Brumberg have probably had most influence.
Another notable attempt was made by Duesenberry , who accounted for the apparent discrepancy that at any point in time, an individual’s propensity to consume depends on his position in the income scale (taht is on his income relative to others) rather than on the absolute level of income.
Friedman’s Permanent income Hypothesis makes variations in the observed consumption- income ratio depend on differences between the actual income and some concept of “normal” income-in this case called “permanent income”. Permanent income reflects the income derived from “non-human wealth” (capital assets) and from “human wealth” (earning capacity) , while the remainder of actual or “measured”, income comprises all other income elements, attributable essentially to random fluctuations of various kinds. Consumption, analogously, comprises a pemanent component which is determined by permanent income, and a random component which which is termed “transitory” consumption. Permanent consumption is taken to be a constant fraction of permanent income, the value of the constant fraction for each consumer depending on a variety of factors including wealth, rates of inters, tastes and preferences.
The Life-Cycle Hypothesis results from on attempt to derive an aggregate consumption function from the conventional microeconomic analysis of consumer choice . It is supposed that individuals derive utility from their lifetime streams of consumption and from the bequathing of assets to their heirs. This utilty is to be maximazed subject to the constraint of the stream of expected earnings , and the functions of saving (or dissaving) is then to cope with situations in which current actual income is not equal to the optium level of current consumption. More formally , if the proportion of his total resources which a consumer plans to consume at some future date is determined only by his tastes and not by the size of his resources (and if the receipt and leaving of legacies are neglected) , then , the consumption of any individual will be proportional to the present value of his total resources- that is to his net worth carried over from the previous perion plus current income plus the discounted value of future income receipts. If certain simplfying assumptions are made-that consumption functions for individual of the same age are identical, and that the age-structure of the population and relative distributions of income, net worth and expected future income are all constant this relationship may be aggregated over all consumers to give an aggregated consumption function in which consumption depends on net worth, current income, and expected income.
A main characteristic of this study is to provide a fundemantal microeconomic model for the Life-Cycle and Permanent Income Hypotheses in Chapter II. Macroeconomics is not merely more closely oriented than microeconomics towards policy problems but depends on them for its very existence. As pointed out by Summer and Zis (1984) , it is a commonlace that in a world which functioned as smoothly as a Walrasian general equilibrium system , the demand for money would be less sinificant than the demand for peanuts ; indeed, it is difficult to visualize any demand for money as such. There would be no difficulty in determining current investment, since future demand for consumption needs would be declared in advance. The consumption function, a fundamental component of all macroeconomic models, would make no sense because current income, instead of acting as an exogeous constraint on consumer’s expenditure would be determined endegeously along with the demand for goods as the outcome of utility-maximizing choices by individual market participants. A statistical relationship between consumption and income would still exist, but it would be devoid of any economic significance. It is only when the conditions assumed in the fullest development of microeconomics do not hold that macroeconomic problems emerge and the central relations of macroeconomics become proper subjects for study.
The conclusion of the Chapter III can be summarized as follows : Despite its central importance in macroeconomics theory , the theory of aggregate consumption behavior skill lacks a really satisfactory underprinning. At the same time , a number of emprical generalizations seem to have been established. First , consumption depends only rather weakly on current income. Rather , it depends either on wealth or some notion of normal income, both of which will be only marginally affected by short-run changes in actual income. Secondly, most satisfactory versions pf the time- series consumption function relate the current level of consumption to current income and to lagged consumption. When this formulation is adopted, it becomes virtually to distinguish empirically between several apparently competing hypotheses. Thirdly , cross-section data must be explained, at least in part, by the variability of household incomes. Finally, there is a presumption that in a long-run stationary equilibrium, savings would be zero; adjustment lags of one short or anther explain cycling movements in the savings ratio, while the secular growth of real income (and perhaps of population) must be elements in the explanation of positive aggregate savings ratio which are observed.
In the final chapter an emprical comparisan or the competing theories was made with various consumption functions using cross- section data collected from the urban Adana. It was seen that only two consumption function specifications among the thirty can be acceptable as succesful. The first one of these two functions is the distrubuted lag form of the Permanent Income Hypothesis.
The second one is the distributed lag form of the Life-Cycle Hypothesis. Comparison of the marginal propensity to consume out of these models show that the distrubuted lag form of the Life-Cycle Hypothesis predicts the long-run marginal propensity to consume more correctly. However , the long-run marginal propensity to consume out of the distributed lag form of the Permanent Income Hypothesis does approach to the expected level.