Absolute income hypothesis

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).

Background

Keynes' General Theory in 1936 identified the relationship between income and consumption as a key macroeconomic relationship. Keynes asserted that real consumption is a function of real disposable income, total income net of taxes. As income rises, the theory asserts, consumption will also rise but not necessarily at the same rate. When applied to a cross section of a population, rich people are expected to consume a lower proportion of their income than poor people

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.

Model

$C_{t} = \lambda Y_{t}$

Where:

• $C_{t}$ is consumption at time t.
• $\lambda$ is the Marginal propensity to consume ($0<\lambda<1$)
• $Y_{t}$ is income at time t.

References

• Keynes, John M. The General Theory of Employment, Interest and Money. London: Macmillan, 1936.