This paper is based on a long-term research program with Rachel Kranton on the implications of identity

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For example, Katz-Gerro (1999) uses data from the General Social Survey to show the different music

preferences of different social classes.

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explanations, or the basis of their explanations on introduction of frictions into the two-period

model of utility maximization.

But there is the alternative possibility: that it is the nature of the utility function itself that

is responsible for the breakdown.   Perhaps that was Keynes’ precise intent in describing the

dependence of consumption on current income as due to a psychological law.

A good place to search for such a psychological law occurs in what economists have

systematically left out of utility functions: components of utility functions related to how people

think they should or should not behave.   There is considerable work in sociology that discusses

the extent to which consumer choice at the micro level is not just determined by income.  It is

also dependent on what the consumer thinks he should consume.  Bourdieu (1984), for example,

has claimed that different patterns of cultural consumption, associated with norms of what

people of different class origins think they should consume, plays an important role in the

reduplication of the class structure itself from one generation to the next.  However, we do not

need to look at attitudes toward music or high culture (like Bourdieu and his followers

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) to see

such norms.  As shown by a recent study (Woodward (2003)), the dependence of consumption

decisions on how people think they should or should not behave, can be seen even at the most

prosaic level: in the explanations of their home-furnishing choices by middle-class Australian

homeowners.  These housewives not only had varying criteria for their selections (for example

between the weight placed on appearance versus the weight placed on comfort); tellingly, they

also viewed their own choices as morally right, and the alternatives as morally wrong. 

While consumers’ concerns for their home furnishings or even their consumption of

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Such a mental calculus accords with equity theory in social psychology.  The key relation in equity theory

is that profits should be proportional to investments, a rule that sounds as if it comes from economics.  The important

distinction in equity theory in social psychology that is different from economics, however, is that both the profits

and investments are to be seen not just in objective terms but in psychological terms as well.  An excellent exposition

is given by Brown (1986. pp. 74-88).

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Kenneth Chang and Dennis Overbye, “Planet or Not, Pluto Has Far-out Rival,” New York Times, July 31,

2005, p. 1.

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culture and music will not affect macroeconomics one whit, related views regarding how much

they should or should not consume will affect the consumption function.  Such views will easily

account for the special relation between current income and current expenditure.  It is natural for

people to think that they can consume more if they deserve it, and an increase in their current

income gives the most natural reason why they might deserve more.  Thus the very tight relation

between consumption and disposable income may not occur only because it gives consumers a

good way to discipline their spending to correspond to their income, but also because it

corresponds to a moral calculus that when people do something they deem worthy, they think

they deserve to spend more as well.

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   There are many signs that people have such a disposition. 

They include strong pay-day effects, whereby those paid monthly spend more in the aftermath of

pay-day than over the rest of the month (Huffman and Barenstein (2003)).  Or when people reach

some milestone that takes some accomplishment, perhaps even the passing of yet another year,

they think they deserve a celebration.  The recent discoverer of what may be deemed the tenth

planet expressed a similar thought: he was going to consume ten bottles of champagne.

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VI.  Investment and Cash Flow and Income

The debate concerning the nature of the investment function has surprisingly close

parallel to the debate about the consumption function.  The early Keynesians emphasized two

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See especially Meyer and Kuh (1957).

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variables as determinants of investment: current cash flow (with profits as a major component)

and also the firm’s current holdings of liquid assets.   Each of these variables is a measure of

funds available to firms for investment without seeking outside finance.

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  In contrast, the later

literature denied any special role of liquidity in the investment function.    

The first such questioning came from Modigliani and Miller, who assumed that managers

maximize shareholder value and that markets are frictionless and competitive.  In this case a

firm’s liquidity position plays no role in its investment decisions.  The argument for

independence proceeds as follows.  By construction, Modigliani and Miller show how a

competitive equilibrium changes if a firm increases its debt.  In the new equilibrium, investment

will be unchanged; and shareholders will offset the increase in the firm’s debt by a compensating

decrease in the bonds in their respective private portfolios.  The reason the equilibrium changes

in this way is straightforward: If the markets for debt cleared in the old equilibrium, they will

again clear in the new.  If managers’ choice of investment maximized shareholder value in the

old equilibrium, the same choice of investment maximizes it in the new.  Investment is therefore

independent of the firm’s finance decision about its current financial position, including its

current liquidity position and its current cash flow.  

The advent of q-theory further questioned a special place for current variables, such as

cash flow and liquid asset holdings in the investment decision.   In the original version of the

theory, James Tobin (1969) suggested that a firm’s optimal investment strategy arbitrages

between the value at which it can sell a unit of its capital and its investment costs to produce a

new unit of capital.  In this case the firm will invest up to the point where the marginal cost of a

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