The Keynesian theory (known as the absolute income hypothesis) is that current real disposable income is the most important determinant of consumption in the short run.

Real Income is money income adjusted for inflation. For example, a 10% rise in money income may be matched by a 10% rise in inflation. This means that real income (the quantity or volume of goods and services that can be bought) has remained constant. Disposable Income (Yd) = gross income - (deductions from direct taxation + benefits)

The standard Keynesian consumption function is written as follows:

C = a + c Yd where,

C= Consumer expenditure a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as dis-saving. c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional pound earned that will be spent.


Marginal propensity to save (mps) = The change in saving divided by the change in income
Average propensity to consume (apc) = Total consumption divided by total income
Average propensity to save (aps) = Total savings divided by total income (also known as the Saving Ratio)


In Friedman's model, the key determinant of consumption is an individual's real wealth, not his current real disposable income. Permanent income is determined by a consumer's assets; both physical (shares, bonds, property) and human (education and experience). These influence the consumer's ability to earn income. The consumer can then make an estimation of anticipated lifetime income.

The theory suggests that consumers try to smooth out consumer spending based on their estimates of permanent income. Only if there has been a change in permanent income will there be a change in consumption. The key conclusion of this theory is that transitory changes in income do not affect spending behaviour. Suppose a government cuts taxes prior to a general election. If consumers perceive this to be only a temporary reduction in their tax burden to increase the government's popularity, then consumption will remain unchanged. If the tax cut is seen as permanent then this may cause increased spending.


The Life Cycle hypothesis is based on the idea that the level of spending relative to income depends on where the consumer is in their life cycle. It suggests that consumers attempt to even out consumption over their lifetime and as a result will borrow and save at different ages.




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