Absolute Income Hypothesis

A Summary of the Absolute Income Hypothesis

The Absolute Income Hypothesis, as postulated by John Maynard Keynes in his General Theory, states that aggregate consumption is a function of aggregate current disposable income. The theory builds on Keynes’ “Fundamental Psychological Law of Consumption”, which observes that as income increases, consumption expenditure also increases, but by a smaller amount. The Keynesian consumption function can be expressed as:

$C=a+cY$

where:

• $C$ represents consumption expenditure,
• $Y$ is disposable income,
• $a$ is a constant representing autonomous consumption (consumption at zero income),
• $c$ represents the marginal propensity to consume (MPC), the change in consumption resulting from a change in income.

The absolute income hypothesis leads to several key properties:

• The average propensity to consume $APC=C/Y$ falls as income increases. This means that as people earn more, they tend to save a larger proportion of their income.
• The MPC is positive but less than unity $(0<c<1)$. Higher income leads to higher consumption, but the increase in consumption is less than the increase in income.
• Consumption expenditure increases (or decreases) with an increase (or decrease) in income but non-proportionally. This implies that in the short run, the APC is greater than the MPC.

Early empirical studies seemed to support the absolute income hypothesis, finding that families with higher incomes saved more and consumed a smaller proportion of their income. However, post-World War II, the American economy did not experience the stagnation predicted by the hypothesis. Instead, the economy saw a surge in consumption, partly attributed to households converting wartime savings into consumer demand.

Further challenging the absolute income hypothesis were the findings of economists like Simon Kuznets and Raymond Goldsmith. Their studies revealed that while the short-run consumption function is non-proportional (APC > MPC), in the long run, the consumption function becomes proportional (APC = MPC). This “consumption puzzle” highlights the discrepancy between the short-run and long-run behavior of the consumption function.

While the sources don’t explicitly address this, later theories like the Permanent Income Hypothesis and the Life-Cycle Hypothesis were developed to reconcile these observations. These theories argue that consumption is determined by a broader concept of income than just current income, taking into account factors like expected future income, wealth, and life stage.

Income	Consumption	Savings
0	40	-40
100	120	-20
200	200	0
300	280	20
400	360	40
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The Kuznet’s Paradox

Consumption was a proportion of income rather than a function

The Kuznets Paradox arises from the observation that while cross-sectional data and short-run time series data suggest that the average propensity to consume (APC) falls as income rises (meaning that higher-income households save a larger proportion of their income), long-run trend data show no such tendency for the APC to decline over time. This implies that as income grows along its long-run trend, the marginal propensity to consume (MPC) equals the APC.

In simpler terms, the paradox lies in the seemingly contradictory findings that:

• Short-run: Richer households tend to save a bigger portion of their income than poorer households.
• Long-run: As the overall economy grows wealthier, the overall saving rate doesn’t necessarily increase.

Simon Kuznets, in his 1946 study of consumption and saving behavior in the US dating back to the Civil War, highlighted this discrepancy. He observed that the ratio of consumer expenditure to income, or APC, did not exhibit a downward trend over the long run. This finding contradicted the Keynesian Absolute Income Hypothesis, which predicts that the APC falls as income rises.

The sources further illustrate the paradox by showing two different consumption functions:

• Short-run consumption function: A non-proportional relationship between income and consumption, where the APC is greater than the MPC. This function aligns with cross-sectional budget studies and short-term time series data.
• Long-run consumption function: A proportional relationship between income and consumption, where the APC equals the MPC. This function is supported by long-run trend data.

The Kuznets Paradox posed a challenge to economists, prompting efforts to reconcile the contradictory observations of short-run and long-run consumption behavior. The sources mention several theories aiming to address this puzzle, including:

• The Drift Theory of Consumption: This theory attempts to reconcile the short-run and long-run consumption functions by suggesting factors other than income, such as population growth, wealth distribution and migration, influence consumption patterns and can lead to an upward drift in the consumption function over time.
• The Relative Income Hypothesis: Developed by James Duesenberry, this theory posits that consumption decisions are influenced by relative income, meaning individuals compare their income to past peak levels and the incomes of others. It proposes the “Ratchet Effect,” where consumption levels are resistant to downward adjustments during economic downturns, explaining why the APC might not decline as expected in the short run.
• The Permanent Income Hypothesis: Milton Friedman’s hypothesis distinguishes between permanent income (expected long-term income) and transitory income (short-term fluctuations). It argues that consumption is primarily determined by permanent income, with transitory income having little impact. This explains why short-term fluctuations in income might not lead to proportional changes in consumption, while long-run income growth would be associated with a stable APC.
• The Life Cycle Hypothesis: Developed by Ando and Modigliani, this theory proposes that individuals plan their consumption over their entire lifetime, considering expected income, wealth, and retirement needs. It suggests that the APC might remain stable in the long run as individuals smooth their consumption patterns over their lifetime, even as income fluctuates in the short run.

The sources don’t directly provide a definitive solution to the Kuznets Paradox. However, they highlight the importance of considering factors beyond current income when analyzing consumption behavior. The theories mentioned above offer possible explanations for why the relationship between income and consumption might differ in the short run and long run.