Chapter 25: Family, vanity and consumption puzzles
Modern macroeconomic research on consumption/saving starts with Keynes's (1936) well-known consumption function. The first argument of the Keynesian consumption function is that income is the major determinant of consumption and saving. It was an important argument at the time of its establishment, as most economists before 1930 emphasized interest rates as the major determinants. They believed that a higher interest rate indicated higher savings (as the financial reward for saving is higher). Thus Keynes's conjecture was a big breakthrough that was confirmed later on by a great deal of empirical evidence. Income is the primary determinant of how people choose to consume, and the effects of interest rates on consumption are ambiguous. The Keynesian consumption function has two components. The first is autonomous consumption, which is the amount consumed when current income is zero. Keynes presents a reasonable argument. While an individual may not have any income (e.g. a full-time student or temporarily unemployed worker), they may still like to consume at a certain level. The second component is consumption increasing with income. The amount of the consumption increase is only a fraction of the income increase, and Keynes calls this fraction the 'marginal propensity to consume'. In other words, the marginal propensity to consume is between zero and one. An important implication of the Keynesian consumption function is that the saving rate, which is defined as the ratio between saving and income, increases with income. Consider this simple numerical illustration: suppose that the autonomous consumption is 10 and the marginal propensity to consume is 0.5.
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