Empirical data of consumption & investment

1. Cross-section data: which are collected and classified by taking a sample of households according to their income groups over a specific period. These data show that high-income groups have a smaller average propensity to consume than low-income groups. Keynes' consumption function fits quite well with the empirical cross-section data. (According to Keynisian model, if the income of an economy rises, the APC will fall while the APS will increase.

2. Time-series data: Long-run empirical time-series date are collected by finding the relationship between consumption and income over a long period of time. We can see that the consumption function is a straight line from the origin, which means that the APC is a constant throughout the long period during which Y is increasing. We find that the ratio of savings does not increase when the national real Y increases as the actual historical time-series data are considered.

Obviously, Keynes' consumption function does not fit with the empirical time-series data in the long run.

There are two important hypothesis which resolve the apparent conflict between the time-series and cross-section evidence: they are the permanent-income hypothesis developed by Milton Friedman in 1957 and the life-cycle hypothesis at about the same time by Albert Ando and Franco Modigliani in 1963.

Permanent-income hypothesis

The permanent-income hypothesis was proposed by Milton Friedman in 1957 (who also a leader of the Chicago monetarist school of economics and won the Nobel Prize in 1976 for his work on the money theory and analysis on consumption behaviour).

The central idea of the permanent-income hypothesis is simple: people base consumption on what they consider their "normal" income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income which people see as temporary have little effect on their consumption spending.

The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time.

In order to test the theory, Friedman assumed that on the average people would base their idea of normal or permanent income on what had happened over the past several years. Thus if they computed permanent income as the average of the past four years, and income had been $13,000, $10,000, $15,000, and $8,000, they would consider their permanent income as $11,500,¹ though our expectations of future income do not depend solely on what has happened in the past.

Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in consumption and investment may not have a constant multiplier effect.

This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it have a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As with all economic theory, this theory does not describe any particular household, but only what happens on the average.

An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect.

A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold (reveal).

The existence of lags also makes government attempts to control the economy more difficult. Policies taken do not have their full effect immediately, but only gradually. By the time they have their full effect, the problems which they were designed to attack may have disappeared.

¹ This example simplifies what Friedman and others have done. It makes sense to give more weight to recent earnings than to earnings further in the past.

Life-cycle hypothesis

Life-cycle hypothesis postulated by Albert Ando and Franco Modigliani in 1963 tried to explain the conflict between the APS observed from cross-section date and that observed from historical time-series data.

According to their hypothesis, a typical individual have a flow of relatively low income at the early stage and end of life, but high during the middle of life. The individual does maintain a slightly increasing level of consumption throughout his life, and the present value of total consumption would not exceed the present value of total income during the lifetime.

As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Someone who looks ahead to a much higher future income consumes more accordingly.

The life-cycle hypothesis suggests that in the early life, a person is a net borrower; in the middle years, the person will save much more to repay the debt and to put aside part of the income for retirement; in the later years, a person will dissave and consume more than income. Thus by relating the aggregate consumption function to the present value of the expected aggregate income, the APS (also the APC) should remains unchanged as time passes, other things being equal.

In fact, if each person saves zero over his life, then the APS=0 and APC=1.

The life-cycle hypothesis also introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets also matter for consumption.

Modigliani won the Nobel Prize in Economics in 1985 for his work on the life-cycle hypothesis.

Determinants of Investment

By Interest Rate:

In simple Keynesian model, investment is treated as a function of Y but not a function of the interest rate. However, empirically the amount of investment does depend on the rate of interest.

The amount of investment is negatively related to the rate of interest.

The higher the interest rate, the lower will be the amount of investment.