The Consumption Puzzle

# The Consumption Puzzle - decades we obtain a curve like the...

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The Consumption Puzzle C A C B Y A Y B C Y C A C B Y A Y B C Y When we estimate the Total Consumption curve using short run annual data we get a graph such as the one on the left with a positive intercept. If we draw a ray from the origin through the point C A -Y A the slope of that ray is vertical distance divided by horizontal distance which is C A divided by Y A . C/Y is the formula for the Average Propensity to Consume so the slope of the ray is the APC for income level Y A . When we draw a ray from the origin through point C B -Y B we see that the ray is now flatter than before. Therefore, we have found that the APC is dropping as income increases (and the rays become flatter). When we estimate the Total Consumption curve over long periods such as
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Unformatted text preview: decades, we obtain a curve like the one on the right above. That curve has an intercept equal to zero. The same ray from the origin goes through C A-Y A and C B-Y B . Because one ray goes through both points the slope is the same and the APC is constant as income increases. The Consumption Puzzle then is “Is the APC constant with increases in income or does it decrease with increases in income?” Two famous theories of the Consumption Function have attempted to answer that question. The first is the “Life Cycle Theory of Consumption” by Franco Modigliani and the second is the “Permanent Income Theory” by Milton Friedman....
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