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The Consumption Function

  • John J. Heim


    (Department of Economics, Rensselaer Polytechnic Institute, Troy, NY 12180-3590, USA)

Keynes held that it was mainly current income that determined the demand for consumer goods and services. He also suggested wealth, interest rates, and taxes may have smaller effects. Later theories by Modigliani and Friedman, based on long term average income as the income variable determining consumption, reach pointedly different conclusions about the effectiveness of Keynesian stimulus than Keynes suggested. Little systematic testing has occurred in recent decades to determine what really is in the consumption function, and what the relative importance of different variables is; Macroeconomics textbooks are decidedly ambiguous in answering these questions, presumably for lack of adequate testing. This paper econometrically tests the relative impact on consumption of different variables in Keynes original hypothesis and compares Keynes to the Friedman/Modigliani hypotheses as well. The paper also tests a “crowd out” variable to measure the effect of government deficits on the availability of consumer credit, and an exchange rate variable, which other studies have found important. Using U.S. data for 1960 - 2000, this study concludes that current income is by far the most important single determinant of consumption, explaining 68% of variance. It is followed in importance by the “crowd out” variable, which explains an additional 14%. Next in terms of explaining additional variance, the study finds wealth (5%), consumer interest rates (2%) and exchange rate changes (1%). Using a Friedman/Modigliani income average instead of the Keynesian income variable markedly reduces the model’s explanatory power. However, adding the same income average to the model, in addition to the Keynesian variable, raises explanatory power slightly, from 92% to 93%, and the variable is statistically significant. From this the study concludes that the consumption behavior of Americans isoverwhelmingly Keynesian in nature, but that a small, separate, portion of the populace is Friedman/Modigliani in consumption behavior, creating a far smaller, but still systematic additional impact on consumption in the same direction as the Keynesian impact. JEL C51, C52, E20, E21, E62Creation-Date: 2008-01

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Paper provided by Rensselaer Polytechnic Institute, Department of Economics in its series Rensselaer Working Papers in Economics with number 0805.

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Date of creation: Feb 2008
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Handle: RePEc:rpi:rpiwpe:0805
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