A Historical Perspective of the Marginalization of Absolute and Relative Income Hypotheses of Consumption
In Keynes’ consumption theory absolute income is the major determinant of consumption. As a consequence, the marginal propensity to consume determines the magnitudes of fiscal multipliers. Keynes was unwilling to ground his theory on any microeconomic foundations, implicitly rejecting the mainstream model of rational consumer. J. Duesenberry extended and improved Keynes’ approach by emphasizing the role of interdependent preferences (the relative income hypothesis). Similar conclusions regarding the role of income on consumption, and therefore support for Keynesian policies, are reached by Duesenberry’s analysis. In the post war era and after a period of testing Keynes’ consumption theory, the emerging trend was to ground the consumption function on mainstream microeconomic principles and especially on the theory of rational consumer. The life-cycle hypothesis by Modigliani and Brumberg (1954), and the permanent income hypothesis by Friedman (1957), emerged as the two main alternatives to Keynes’ and Duesenberry’s approaches. One common feature of these two consumption functions was the diminished role of current income in consumption. This implied very small fiscal multipliers and therefore a limited role for fiscal policy. The paper argues that these rational consumer based consumption functions can also be seen as a reaction against the Keynesian emphasis on fiscal policy. Eventually, the absolute and relative income hypotheses were replaced by mainstream consumption functions based on individual maximizing behaviour. It will also be argued that the replacement process was not centred on their theoretical or empirical failure, but on their allegedly psychological and sociological nature, a characteristic which was unacceptable on methodological grounds. The clear implication of the discussion is that the marginalization of absolute and relative income hypotheses was due to the dominance of a specific methodological framework that did not favour such approaches.
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Keywords: Consumption Function, Keynes, Duesenberry, Economic Methodology