Keynes conjectured that the marginal propensity to consume is between zero and one, that the average propensity to consume falls as income rises, and that current income is the primary determinant of consumption. Studies of household data and short time-series confirmed Keynes’s conjectures. Yet studies of long time-series found no tendency for the average propensity to consume to fall as income rises over time.
Recent work on consumption builds on Irving Fisher’s model of the consumer. In this model, the consumer faces an intertemporal budget constraint and chooses consumption for the present and the future to achieve the highest level of lifetime satisfaction. As long as the consumer can save and borrow, consumption depends on the consumer’s lifetime resources.
Modigliani’s life-cycle hypothesis emphasizes that income varies somewhat predictably over a person’s life and that consumers use saving and borrowing to smooth their consumption over their lifetimes. According to this hypothesis, consumption depends on both income and wealth.
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Friedman’s permanent-income hypothesis emphasizes that individuals experience both permanent and transitory fluctuations in their income. Because consumers can save and borrow, and because they want to smooth their consumption, consumption does not respond much to transitory income. Instead, consumption depends primarily on permanent income.
Hall’s random-walk hypothesis combines the permanent-income hypothesis with the assumption that consumers have rational expectations about future income. It implies that changes in consumption are unpredictable, because consumers change their consumption only when they receive news about their lifetime resources.
Laibson has suggested that psychological effects are important for understanding consumer behaviour. In particular, because people have a strong desire for instant gratification, they may exhibit time-inconsistent behaviour and end up saving less than they would like.