The independence of consumption and current income

The second neutrality Akerlof tackles is: “Other than its contribution to a consumer’s wealth, current income has no independent effect on the consumption of a utility-maximizing consumer.” (Akerlof 20)

This hypothesis was slowly developed through the work of Irving Fisher, Milton Friedman and John Maynard Keynes. Fisher formed a model of an individual’s consumption over two periods, expressed by:

C= U(c1, c2)

c1 signifies the first period, c2 signifies the second period, and U signifies utility. Looking at this function, Friedman reasoned, if the consumer maximizes the function, “a dollar of income earned today will have the same effect on her current consumption as a discounted dollar earned in the second period.” Friedman believes a consumer will spend the portion of his wealth that will still ensure long-term security. This portion of his wealth is defined as permanent income.

Friedman’s permanent income hypothesis: consumption is affected by permanent, not current income. A consumer will spend more of their income if interest rates are in their favor.

John Maynard Keynes also argues that an individual's economic decisions are dependent on their current disposable income. Traditional macroeconomic theory claims that consumer spending is predictable, follows certain rules and can be easily calculated. Keynes' consumption function is:

C = a + cYd

C signifies consumer expenditure, a signifies autonomous consumption, or necessary expenses. c signifies marginal propensity to consume, or MPC. MPC, is the increase in consumer spending when disposable income rises by $1, because of a pay rise or a decrease in expenses.

MPC = (change in consumer spending / change in disposable income)

Keynes wrote, “the fundamental psychological law, upon which we are entitled to depend with great confidence… men are disposed, as a rule and on the average, to increase their consumption as income increases, but not by as much as the increase in income” (Keynes, The General Theory, 1936 p. 96). Keynes and his followers assumed the MPC was an reliable tool for predicting consumer spending and economic trends in the future.

However, Akerlof's research suggests that an individual's rationale is more complex, and includes other factors. These factors could persuade the individual to consume more than their disposable income allows. According to Akerlof's research, consumption and current income are disconnected because:

1. Sociology argues that consumption is determined by what people believe they should consume, whether these are qualified as entitlements or as obligations, and current income can be an entitlement or an obligation.

2. Sociologists also say that consumption is largely dictated by social expectations, and what people believe they are expected to do, and what they aspire to be.

3. Entitlements are when people believe they have earned something special, after working for a while. Obligations are when people feel pressured to spend, according to the standards in their social circle.

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• Back to the home page for Behavioral Economics

• Ricardian equivalence

• The independence of consumption and current income

• The independence of investment and finance decisions

• Inflation stability only at the natural rate of unemployment

• The ineffectiveness of macro-stabilization policy with rational expectations