Investigating the Existence of Co-integration Relationship in the Consumption Function

Although more than 80 years are passed from the time that Keynes hypothesized that consumption is a function of disposable income, yet there is no consensus among economists on this issue. Some economists argue that consumption is a function of wealth. Recently, new macroeconomic theory, based on micro-foundations has revealed some facts that wealth is the main determinant of consumption in the long run. Those empirical studies that assumed consumption is only a function of disposable income, have failed to reach a co-integrated consumption relationship. The analysis based on newly developed theory of co-integration has revealed that consumption, income and wealth are all integrated of order one, so they can form a long run co-integrated relationship. Life Cycle hypothesis of Ando and Modigliani states that consumption of a person is related to his/her age. If this is true, ignoring the age structure of the population in the consumption function could lead to a non co-integrated relationship. This article, with the aim of finding a set of co-integrated variables for the consumption function, drives and estimates an aggregated consumption function. It is found that a co-integrated relationship could only exist if wealth and age-structure variables are included in a consumption function. Moreover, marginal propensity to consume out of disposable income is estimated to be 0.6 and 0.52 in the urban areas. These figures for the rural areas are estimated to be almost 0.7 . As far as the average propensity to consume (APC) is concerned, those who belong to the age group of 50-69 have the least APC. Results from estimating the Error Correction Models (ECM) show that the speed of adjustment towards equilibrium level of consumption is relatively low , since almost 34% of disequilibrium error is adjusted in each period.