The Relative Income Theory of Consumption: A Synthetic Keynes-Duesenberry-Friedman Model

This paper presents a theoretical model of consumption behavior that synthesizes the seminal contributions of Keynes (1936), Friedman (1956) and Duesenberry (1948). The model is labeled a “relative permanent income” theory of consumption. The key feature is that the share of permanent income devoted to consumption is a negative function of household relative permanent income. The model generates patterns of consumption spending consistent with both long-run time series data and modern empirical findings that high-income households have a higher propensity to save. It also explains why consumption inequality is less than income inequality.