1)      Absolute Income Hypotheses (Keynes?)

2)      Relative Income Hypothesis (James Duesenberry 1949 ~ From Thorstein Veblen)

3)      Permanent Income Hypothesis (Friedman)

4)      Life Cycle Hypothesis (Ando & Modigliani)

Theories 3 and 4 are most compatible with Neo-classical economics.

The Absolute Income Hypothesis

C^D = a = bY_t

 The current level of consumption is a straightforward function, driven by the current level of income.  This implies that people adapt instantaneously to income changes.

- there is rapid adaptation to income changes

            - the elasticity of consumption to current income changes

The elasticity with respect to current income in other theories will be less.  They reduce the sensitivity to current income flows.

The Relative Income Hypothesis

The Duesenberry approach says that people are not just concerned about absolute levels of possession.  They are in fact concerned about their possessions relative to others, “Keeping up with the Jones.”

People are not necessarily happier if they have more money.  They do however report higher happiness if they have more relative to others.

Current economists still support this idea. Ex: Robert Frank and Juliet Schor

Duesenberry argues that we have a greater tendency to resist spending decreases relative to falls in income than we do to increase expenditure relative to increases of income.  The reason is that we don’t want to alter our standard of living downard.

C_T = a +bY_T + cY^X

Y^X is the previous peak level of income (this keeps expenditure from falling in the face of income drops).  It is also known as the Drag Effect.

A shift in expenditures relative to a previous level of income is known as the Ratchet Effect, and will be shown below.

Duesenberry argues that we will shift the curve up or move along the curve, but not we will resist shifts down.  When WWII ended, a significant number of economists claimed that there would be a consumption decline and aggregate demand drop which did not occur.  This provides supporting evidence.

A long-run consumption function can be drawn, assuming that there is a growth trend.  If this is true, previous peak income would have been that of last year and thus would give a consumption function that looks like it depends on current income.

Permanent Income Hypothesis

-Also explains why there was no drop collapse in spending post WWI.

Friedman argues that it would be more sensible for people to use current income, but also at the same time to form expectations about future levels of income and the relative amounts of risk.

Thus, they are forming an analysis of “permanent income.”

            Permanent Income = Past Income + Expected Future Income

Transitory Income – income that is earned in excess of, or perceived as an unexpected windfall.  If you get income not equal to what you expected or to what you don’t expect to get again.

So, he argues that we tend to spend more out of permanent income than out of transitory.

In the Friedman analysis, he treats people as forming their level of expected future income based on their past incomes.  This is known as adaptive expectations.

Adaptive Expectations – looking forward in time using past expectations.  In this case, we use a distributed lag of past income.

Y^P_t+1 ® E(Y_t+1) = B₀Y_t + B₁Y_t-1 + B₂Y_t-2…

Where B₀ > B₁ > B₂

It is also possible to add a constraint: B₀ + B₁ + B₂ + B₃ + … B_n = 1

This is expected income, the actual income can be thought of as:

Y_t-1 – Y^p_t+1 = Y^t_t+1

Using this, we can construct a new model of the consumption function:  

C_t = a = bY^D_t + cY_t^t

There are other factors that people can look at to think about future levels of income.  For example, people can think about future interest rates and their effect on their income stream.  If you were Friedman, you would do this by using a distributed lag of past incomes.

The Life Cycle Hypothesis

This is primarily attributed to Ando and Modigliani

The basic notion is that consumption spending will be smooth in the face of an erratic stream of income.

Working Phase:

1. Maintain current consumption, pay off debt from youth years
2. Maintain current consumption, build up reserves

Age distribution now matters when we look at consumption, and in general, the propensity to consume.  Debt and wealth are also taken into account when we look at the propensity to consume.  The dependence structure of the population will affect or influence consumption patterns.

Lester Thurow (1976) – argued that this model doesn’t work because it doesn’t presume there is any motive for building wealth other than consumption.  Thurow argues that their real motivation is status and power (both internal and external to the family).

The permanent income hypothesis bears a resemblance to the life-cycle hypothesis in that in some sense, in both hypotheses, the individuals must behave as if they have some sense of the future.

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