Answer to Question #162440 in Macroeconomics for fami

Question

What were Keynes’s three conjectures about the consumption function? Describe the evidence that was consistent with Keynes’s conjectures and the evidence that was inconsistent with them. Explain how do the Permanent-Income hypothesis and the Life Cycle hypothesis resolve the seemingly contradictory pieces of evidence regarding consumption behavior?

Answer 1

Keynes conjectured marginal propensity to consume. Marginal propensity to consume refers to an increase in consumption due to an increase in disposable income. According to Keynes, the MPC is between zero and one. This means an increase in income will increase both consumption and saving.

Keynes conjectured average propensity to consume. According to him, as income increases, the APC goes on decreasing. This means, rich will save more than the poor. 

Keynes conjectured that income is the primary determinant for consumption.

Keynes conjectured for both life-cycle and permanent hypothesis emphasize that an individual’s time horizon is longer than a single year.

According to the life-cycle hypothesis, the income will vary over a person’s life. This means consumers save more when income is more and less will save when income is low. Here, consumption will depend on wealth and income.

Consumption function:

C = αW + βY

Conventional Keynesian consumption function occurred with fixed wealth in the short-run. As wealth increases in the long-run, the short-run consumption function will shift to the rightward.

Permanent income hypothesis: according to this hypothesis, people will try to smooth their consumption rather than focusing on income over fife time. Here, people will experience changes in the income year to year.