Absolute income hypothesis (1936)

Proposed by English economist John Maynard Keynes (1883-1946) as part of his work on the relationship between income and consumption, absolute income hypothesis was much refined during the 1960s and 1970s, notably by American economist James Tobin (1918-2002).

Keynes’ General Theory in 1936 identified the relationship between income and consumption as a key macroeconomic relationship. Keynes asserted that real consumption (ie adjusted for inflation) is a function of real disposable income, which is 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.

The 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.

The study investigates how consumption expenditure is determined by income according to Keynes’ Absolute Income Hypothesis (AIH) for the case of Nigeria and thus presents a consumption function for Nigeria for the period 1970 to 2011, estimating total household consumption expenditure against total income. The AIH model was tested by ordinary least squares over the period using data obtained from the World Bank national accounts data and Ivan Kushnir’s Research Center. We described and tested two important theoretical predictions of the Keynesian AIH model; first, that the marginal propensity to consume (MPC) is constant and, second, that the average propensity to consume (APC) declines as income increases. Using Nigeria economic data, we estimated parameter MPC and APC both for short run and long run time series. The results shows that MPC conform with Keynes earlier proposition that MPC is less than one, however it is not stable and the value of the autonomous consumption is negative in the long run. We found also that the APC did not vary systematically with income as conjectured by Keynes that it declines as income increases. As a result, the income elasticity of consumption does not follow Keynes prediction. The absolute income hypothesis fits well for Nigeria data in the short run. In the long run, with the elasticity of consumption of about 1 or above 1, evidently there are other important determinants of consumption other than income.

Consumption is a non-linear function of income. As income rises, consumption will rise but not necessarily at the same rate.

In its developed form, absolute income hypothesis is still generally accepted.

Also see: relative income hypothesis, permanent income hypothesis, life-cycle hypothesis