Questions for Review
1. First, Keynes conjectured that the marginal propensity to consume—the amount con-
sumed out of an additional dollar of income—is between zero and one. This means that
if an individual’s income increases by a dollar, both consumption and saving increase.
Second, Keynes conjectured that the ratio of consumption to income—called the
average propensity to consume
—falls as income rises. This implies that the rich save a
higher proportion of their income than do the poor.
Third, Keynes conjectured that income is the primary determinant of consump-
tion. In particular, he believed that the interest rate does not have an important effect
A consumption function that satisfies these three conjectures is
is a constant level of “autonomous consumption,” and
is disposable income;
marginal propensity to consume, and is between zero and one.
2. The evidence that was consistent with Keynes’s conjectures came from studies of house-
hold data and short time-series. There were two observations from household data.
First, households with higher income consumed more and saved more, implying that
the marginal propensity to consume is between zero and one. Second, higher-income
households saved a larger fraction of their income than lower-income households,
implying that the average propensity to consume falls with income.
There were three additional observations from short time-series. First, in years
when aggregate income was low, both consumption and saving were low, implying that
the marginal propensity to consume is between zero and one. Second, in years with low
income, the ratio of consumption to income was high, implying that the average propen-
sity to consume falls as income rises. Third, the correlation between income and con-
sumption seemed so strong that no variables other than income seemed important in
The first piece of evidence against Keynes’s three conjectures came from the fail-
ure of “secular stagnation” to occur after World War II. Based on the Keynesian con-
sumption function, some economists expected that as income increased over time, the
saving rate would also increase; they feared that there might not be enough profitable
investment projects to absorb this saving, and the economy might enter a long depres-
sion of indefinite duration. This did not happen.
The second piece of evidence against Keynes’s conjectures came from studies of
long time-series of consumption and income. Simon Kuznets found that the ratio of con-
sumption to income was stable from decade to decade; that is, the average propensity to
consume did not seem to be falling over time as income increased.
3. Both the life-cycle and permanent-income hypotheses emphasize that an individual’s
time horizon is longer than a single year. Thus, consumption is not simply a function of