Was Keynes Right? Does Current Year Disposable Income Drive Consumption Spending?

Abstract: In the Keynesian consumption function, current income is asserted to be the main determinant of consumption. This paper examines the extent to which the Keynesian consumption function explains 1960- 2000 U.S. consumption patterns. The results are compared to the longer term average income variables suggested by Friedman’s Permanent income Hypothesis and Ando and Modigliani’s Life Cycle Hypothesis as the income variable affecting consumption. We find variance explained by the consumption function drops dramatically when multi-year average incomes are substituted for the Keynesian current income variable. However, when added to the Keynesian function as a second income variable, they increase explained variance from 88 % to 90%, compared to the Keynesian income variable alone. This small amount suggests that their may be a small portion of the U.S. population whose consumption decisions follow the more complex formulations suggested by the Permanent Income and Life Cycle hypotheses, while the simpler current income formulation used by Keynes appears to characterize the consumption function of most of the population. JEL E00, E12