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Absolute income hypothesis

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The Absolute Income Hypothesis is theory of consumption proposed by English


economist John Maynard Keynes (1883–1946), and has been refined extensively during
the 1960s and 1970s, notably by American economist James Tobin (1918–2002).[1]

Contents
[hide]

• 1 Background
• 2 Model
• 3 Notes

• 4 References

[edit] Background
The theory examines the relationship between income and consumption, and asserts that
the consumption level of a household depends on its absolute level (current level) of
income. As income rises, the theory asserts, consumption will also rise but not
necessarily at the same rate.[2]

Marginal propensity to consume is present in Keynes' consumption theory and


determines by what amount consumption will change in response to a change in income.

While this theory has success modeling consumption in the short term, attempts to apply
this model over a longer time frame have proven less successful. This has led to the
absolute income hypothesis falling out of favor as the consumption model of choice for
economists.[3]

[edit] Model
Ct = λYt
Where:

• Ct is consumption at time t.
• λ is the Marginal propensity to consume (0 < λ < 1)
• Yt is income at time t.

Relative income hypothesis


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Developed by James Duesenberry, the relative income hypothesis states that


individual’s attitude to consumption and saving is dictated more by his income in relation
to others than by abstract standard of living. So an individual is less concerned with
absolute level of consumption than by relative levels. The percentage of income
consumed by an individual depends on his percentile position within the income
distribution.

Secondly it hypothesises that the present consumption is not influenced merely by present
levels of absolute and relative income, but also by levels of consumption attained in
previous period. It is difficult for a family to reduce a level of consumption once attained.
The aggregate ratio of consumption to income is assumed to depend on the level of
present income relative to past peak income.

[edit] References
Dusenberry, J. S. Income, Saving and the Theory of Consumer Behaviors. Cambridge:
Harvard University Press, 1949.