Abstract

The task entails conducting a research to establish whether China Urban and Rural consumers portray a Keynes consumption function in the period between 1978 and 2015.Data was collected from the World Bank website pertaining China GDP and Household consumption expenditure. Then a Simple regression analysis was carried out using Eviews software. The findings were that the model developed using the data takes the form of Keynes theory. This is because a positive MPS of 0.65 which shows that consumption does not change proportionately with income. Also, the coefficient of income in the model is positive which suggest that an increase in income leads to increase in consumption. Finally, P-value of GPD and f-statistic of the model are greater than 0.05 which prompts acceptance of the H0 that China urban and rural consumption function takes the form of keys function.

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Table of Contents

SECTION ONE4

Introduction4

SECTION TWO6

Literature Review6

SECTION THREE13

Methodology13

SECTION FOUR16

Discussion of Research Findings16

SECTION FIVE17

Conclusion17

REFERENCES18

References18

**SECTION ONE**

**INTRODUCTION**

The Chinese economy has experienced a significant growth over the years as a result of policy reforms adopted by previous regimes and opening-up of the economy. This has led to a great growth of the living standards of both urban and rural citizens. Improvement in living standards translates to growth in consumption in the economy.For example, According to (Yumeng & Yuneng, 2016), the residential consumption in China has grown from 184 yuan in the year 2001 to 10919 Yuan in the year 2010. This represents a 58342% growth in consumption in residential sector which is significantly high. Residential consumption is the level of consumption at which people can meet a sustainable level of descent living (Yumeng & Yuneng, 2016)

Residential consumption is a function of GDP performance in an economy. This means, the GDP growth in an economy will dictate the level of citizens residential consumption. If the GDP is high and growing, residential consumption will increase and the vice versa is true.This is an indicator that GPD of an economy drives the consumption pattern (Yumeng & Yuneng, 2016).According to Keynes’s theory, consumption on an individual is subject to his / her current income. Also (Shengjin, 2011), the GDP of China grew from $ 148 Billion in the year 1978 to $ 2.713 trillion. This makes China be the second largest economy in the world after the US and a Key player to Global economy (Yumeng & Yuneng, 2016)

However, the Consumption function of China has been a subject of debate over the years as it shows an abnormality over the general Keynesian theory of consumption. Various Scholars have attempted to explain the nature of consumption curve in China and have not yet reached a consensus. This is because contradicting findings have been brought forward by different researchers who have attempted to explain the Chinese consumption curve.Therefore, this is the research Gap I want to establish. This research will contribute to the existing literature on the nature of China Keynes curve.It is a matter of interest to scholars and policymakers as China is the largest economy globally and would be important to understand the nature of its economy through consumption theory (Alimi, 2013)

The main objective of the research will establish the relationship between China Consumption and the level of income as proposed by the Keynes theory. This will be evaluated by evaluating the nature of China consumption curve for both urban and rural citizens. Most of the prior researches done where focusing on the consumption curve based on either rural populations and Urban populations separately. This research will go further to evaluate China Consumption curve by combining both the Urban and rural populations (Ilan, et al., 2011).The hypothesis which the study will be verifying by carrying out this research is will be:

H0: Consumption curve of China rural and urban population takes the form of Keyness theory

H1: Consumption curve of China rural and Urban population does not take the form of Keyness theory.

**SECTION TWO **

**LITERATURE REVIEW**

THEORETICAL REVIEW

It is important to review the existing theories which explain the aspect consumption in order establish the logic behind the subject matter. This will help a researcher to have a prior understanding of the possible relationship between the variables been evaluated. This will be fundamental to ensure a sound model is developed based on analytics and supporting theories. Therefore, an evaluation of existing theory forms a starting ground for conducting the research (Cox, 2011). There is a number of theories which exist to explain the effects of income on consumption of citizens in an economy. The basic theoretical models which explain the relationship between income and consumption are Keynes absolute income theory (1936), Modigliani life cycle hypothesis (1949), Friedman permanent income hypothesis (1957) and Duesenberry relative income hypothesis (1949) among others (Alimi, 2013)

KEYNESS ABSOLUTE INCOME HYPOTHESIS THEORY (AIH)

Keyless is regarded as the father of consumption function research. According to the Keynes argument, a rational consumer will increase his consumption levels at a lower rate as his income increase. He argued that, income the key backbone of consumption and is the only key variable which drives consumer consumption. He based his argument on the basis of human nature and personal life experiences. However, he did not base his argument on a statistical basis and left this to future researchers to establish the relationship between income and consumption. He suggested that consumer consumption is stable and not necessarily linear in nature. He came up with a linear function of the form Ct=β0+ β1Yt where

Ct=Consumer consumption over time t

Yt= Consumer income over time t

T=period under review

β0=Constant Consumption

β1=Marginal propensity to Consume

The marginal propensity to consume according to Keynes is a constant positive number which is less than one. This implies a positive correlation between the Income and consumption which means as the Consumer income increases, the consumption increases in turn. The Keynes model is based on two key features which say that, as the income of a consumer increases, the consumption will also increase and the opposite is true. Based on this feature, the consumption does not change in a proportionate manner. This is attributed to the fact that in short run APC is always greater than MPC. The second feature of the model is based on the argument that, when consumer income increases, his proportion of consumption falls and finally, the consumption model is regarded as stable in both short-run time horizon and long-term horizons (Alimi, 2013)

MODIGLIANI LIFE CYCLE HYPOTHESIS (1949)

This model was developed with the key goal of explaining the differences in findings when time-series data is employed to develop a consumption model and when cross-sectional data is employed.The model incorporates future income of a consumer which is contrary to Keynes model which considers only the current income.It advocates for incorporation of the time value of money aspect and assumes that consumers objective is to maximise their lifetime consumption. It is built on some key relaxing assumptions which include: the income of a consumer is constant up to retirement age and thereafter it becomes zero. This is vague assumption as in reality, the income of a consumer is not constant over time and it’s possible for the consumer to earn income after retirement through other sources apart from employment. Also, It assumes that the interest rates prevailing in an economy are zero which is not true in reality as interest rates can be above zero (Shengjin, 2011)

In addition, the model assumes that the consumer preference is constant in his entire life. This is not true as consumers preference can change with age or even other factors (Alimi, 2013).According to this proposition, the APC is usually higher in young and old consumers. This is because the young are presumed to be servicing debts which make them have low disposable income or even negative net worth. The age is assumed to be depending on constantly limited pension at their retirement days. The middle-aged are assumed to have a relatively constant APC since they have high earnings and accumulated savings. The model takes the form of

C= (W+RY)/T

Where:

C= consumption

W= Initial endowment wealth

R= Number of years earning employment income

Y=Employment income

T=Individual consumer life span

This can be rewritten as

C=ʎW+βY

Where

ʎ=MPC out of accumulated wealth

β= MPC out of income

FRIEDMAN PERMANENT INCOME HYPOTHESIS (1957)

According to Friedman 1957, he argues that consumers set aside a constant proportion of their income for consumption. According to the model, consumers aim is to obtain the highest utility from the planned consumption income which is constrained and must be fully used during consumer’s lifetime. He argues that consumers plan their consumption by incorporating both current income and future expected income. This implies that consumers plan their consumption based on a long-run view of all possible income resources which they expect to receive at a future date (Friedman, 1971). This model takes the form of

C=Cp+Cy…………….equation 1

Y=Yp+Yt……………..equation 2

Cp=K(r,w,u)*Yp……..equation 3

Equations 1 and 2 provides a means of linking actual variables of consumption and income while equation 3 gives the relationship between permanent consumer consumption and permanent consumer income and MPC from permanent income (Alimi, 2013)

Where

C=Current consumption

Cp=Permanent consumption

Cy=Permannent Income

K-constant

R=interest rate

W=Ratio of wealth to income

U=consumer tastes and preferences

DUESENBERRY RELATIVE INCOME HYPOTHESIS (1949)

According to Duesenberry, the consumer satisfaction from a given level of consumption is derived from society as whole rather than at individual level. This means, consumption of an individual consumer is considered as the average of the entire society rather than the consumer’s absolute consumption. According to Berry, the average saving rate is independent of average income which validates the time series evidence. Also, MPS of a consumer is an increasing function of his weighted income distribution, this is in line with the cross-sectional data evidence. This model also shows consumption as an increasing function of expected future income of the consumer. It was developed to address the shortcomings of Keynes theory which are related to both time series and cross-sectional data (Alimi, 2013)

EMPIRICAL REVIEW

Yumeng & Yuneng, 2016 did a research on Consumption level of rural residents in China with an aim of establishing the factors that cause differences in consumption levels among this group of people. They employed regression analysis to carry out their research which incorporated three independent variables namely, Per Capita Rural disposable income, Rural consumer price index and Rural Engel coefficient to test their relationship with Rural consumption level which was the dependent variable.The research covered a period of 20 years from the year 1991 to the year 2010. It was established that Rural Engel coefficient and rural per capita disposable income variables were found to have a strong positive correlation to rural consumption level. The Rural consumer price index was found to be statistically significant thus was eliminated from the model (Yumeng & Yuneng, 2016)

A similar research was also done by Shengjin, 2011 which entailed comparison of income-consumption curve between China and India covering 30 years from 1978 to 2006. The used regression analysis to establish the relationship between the two variables used namely GDP as the dependent variable and final household consumption as the independent variable.They found out that, India consumption curve is in line with Keynes theory while China Consumption curve was unique. The china Consumption model showed a negative constant income, MPC of more than one and negative time pattern.They attributed the abnormality of China consumption to high optimism on the future income by China consumers and probability of an underground economy with significant resources which is not accounted for in China GDP but was traceable in household consumption data (Shengjin, 2011)

Manzoor, et al., 2016 carried out a research to model private consumption in China for the period 1987 to 2012. The used both Co-integration analysis and autoregressive lag models approach to develop the consumption model. They based their study on AIH and PIH models which incorporate future income of the consumer into the model. The study established that, in the long run, current consumer income and wealth are statistically significant while unemployment and interest rates are not. However, the study found out that, all the four independent variables were statistically significant thus affects the personal consumer consumption in the short run (Manzoor, et al., 2016).

Qing, et al., 2016 did a research based on AIH, PIH and LCH theories to establish the relationship between household consumption and Public pension in China. The research employed pooled regression with panel data to establish the relationship between variables.The result found that the categories of consumers who save more have high consumption and have low MPC while low-income earners and retirees who don’t save have low consumption levels hence have high MPC. This supported the LCH theory which gives the scenario in a theoretical manner (Qing, et al., 2016)

**SECTION THREE **

**METHODOLOGY AND DATA ANALYSIS**

The methodology used to carry out the research involved obtaining data from WorldBank database pertaining to China GDP annual growth rates and Household final consumption expenditure growth rates. Time series data was obtained covering a period of 38 years from the year 1978 to 2015. A simple regression model was run on Eviews software to obtain the consumption model based on Keynes absolute income hypothesis.China GDP annual growth rate is used as the proxy of income for both rural and urban consumers. On the other side, China Household final consumption expenditure annual growth rate is used as the proxy for consumption variable (Gujarati, 2003)

The regression model will be in the form of:

Ct=β0+ β1Yt+µi

Where:

Ct=Household final consumption expenditure for a period of 38 years

β0=Constant income

β1=Marginal propensity to consume

Yt=GDP annual growth rate

µi=Error term

Table 1: Descriptive statistics

China GDP Growth rate | China Household final consumption expenditure growth rate | |

Mean | 9.739622 | 7.375626 |

Median | 9.468128 | 8.525860 |

Maximum | 15.13917 | 19.03356 |

Minimum | 3.907114 | 0.000000 |

Std. Dev. | 2.678068 | 6.017351 |

Skewness | -0.010727 | -0.003113 |

Kurtosis | 2.766270 | 1.837281 |

Jarque-Bera | 0.087226 | 2.140593 |

Probability | 0.957324 | 0.342907 |

Sum | 370.1057 | 280.2738 |

the Sum Sq. Dev. | 265.3658 | 1339.715 |

Observations | 38 | 38 |

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From the analysis of the descriptive statistics, the China GDP annual growth rate is on average 9.74% for the period under review which is quite high. The household consumption expenditure has a mean of 7.37% during the period. This implies that the country consumes less than its income which is an ideal case.The GDP growth rate ranged from 3.90% to 15.13% which is a sign of economic growth in China (WorldBank, 2017)

Table 2: Regression Output

Dependent Variable: HFCEGR | ||||

Method: Least Squares | ||||

Date: 01/07/17 Time: 06:13 | ||||

Sample: 1978 2015 | ||||

Included observations: 38 | ||||

Variable | Coefficient | Std. Error | t-Statistic | Prob. |

C | 1.061612 | 3.618477 | 0.293386 | 0.7709 |

GDPGR | 0.648281 | 0.358558 | 1.808025 | 0.0790 |

R-squared | 0.083245 | Mean dependent var | 7.375626 | |

Adjusted R-squared | 0.057780 | S.D. dependent var | 6.017351 | |

S.E. of regression | 5.840924 | Akaike info criterion | 6.418851 | |

Sum squared resid | 1228.190 | Schwarz criterion | 6.505040 | |

Log likelihood | -119.9582 | F-statistic | 3.268953 | |

Durbin-Watson stat | 0.341736 | Prob(F-statistic) | 0.078963 | |

The Consumption model based on Keynes Absolute income hypothesis from the regression results will be:

HFCEGR=1.061612+0.648281 GDPGR

**SECTION FOUR**

**DISCUSSION OF RESEARCH FINDINGS **

The model obtained from the analysis has an R-squared value of 5.7%. This means that the changes in consumption in rural and urban consumers is affected by their income. In our case,5.7% is the coefficient of variation between China GDP growth rate and Household consumption growth rate. The F-statistic of the model is 0.078 which is statistically insignificant at 95% confidence level meaning that the null hypothesis should be accepted. Therefore, from the f-statistic test, H0 should be accepted meaning Consumption curve of China rural and urban population takes the form of Keyness theory.The P-value of variable GDP is 0.078 which is statistically significant at 95% confidence level. This implies that the H0 should be accepted.

The coefficient of GDP in the model is 0.65 which means that each unit increase in household consumption in China urban and rural population leads to increasing in GDP by 0.65. This is consistent with Keynes theory which argues that consumption and income of a consumer do not change proportionally. This represents MPC which according to Keynes should be less than one which is the case with the consumption model developed.The Constant income in the model has a p-value of 0.77 which is also statistically significant at 95% confidence level. This supports acceptance of the null hypothesis. It has a coefficient of 1.06 which supports the argument of Keynes theory (Gujarati, 2003)

**SECTION FIVE**

**CONCLUSION**

From the analysis of China GDP and Household Consumption for a period of 38 years covering 1978 to 2015, the results show that China Consumption curve takes the form of Keynes Absolute Income hypothesis as the obtained consumption model has an MPC of less than one and a positive constant term which represents constant income.This is supported by the p-values of income and F-statistic of the model which are statistically insignificant. This confirms the hypothesis that China urban and rural consumption curve takes the form of Keyness theory model.Also, the coefficients of Income in the developed model is positive and less than one which shows that China household consumers use less than their income as proposed by the Keyness theory (Alimi, 2013).

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