MA Economics, sem I

macroeconomics

CONSUMPTION PUZZLE:
PERMANENT INCOME
HYPOTHESIS (PART II)

DR. ARVUDA SHARMA

ASSISTANT PROFESSOR
DEPARTMENT OF ECONOMICS
GGDSD COLLEGE CHANDIGARH
 INTRODUCTION

 Permanent Income Hypothesis (PIH) was given by Milton Friedman in

1957. This hypothesis complements LCH as both are based on the theory
of consumer behaviour given by Irving Fisher.
 This theory also, like LCH, recognises consumption expenditure of
current period get influenced by the expected future income
 It is possible to reconcile the short run consumption function to the long
run consumption function.
 According to Friedman

C=f()
C f ()

Concept of income Concept of consumption

Measured or actual
Measured or actual income
consumption

Permanent income Permanent Consumption

Transitory income Transitory Consumption

 Income
According to Friedman
 Total income (actual or measured income) in a given time period is the sum of two components-
Permanent income () and Transitory income ().

Y= +
= Permanent income is defined by Friedman as “ The amount which the consumer unit could consume (or
believe that it could) while maintain its wealth intact”. Or the maximum amount consumer could consume
keeping his/her wealth intact.

= Transitory income component, it can be positive, negative or zero. It represents the deviation of current
income from permanent income or long run average income.
 Permanent income is that income which person expect to persist in the future
 Transitory income is that part of the income which person do not expect to persist in the future
 The sum of these two components is known as actual or measured income of the person in the given
period of time
Ex.
10,000 = 8000 + 2000
Where, 10,000 is income earned in year 2019, 8000 is permanent income and 2000 is transitory income.
Flow of permanent income i.e 8000 will be expected to remain in the future also but income of 2000 is
due to some windfall gain so it is a transitory income.
 Consumption
According to Friedman
 Total consumption (actual or measured consumption) in a given time period is the sum of two components-
Permanent consumption () and Transitory consumption ().

C= +
= Permanent consumption is a planned consumption during a given period of time.
= Transitory consumption component, it can be positive, negative or zero. It is an accidental consumption
which occurs by chance factor. It represents the deviation of current consumption from permanent
consumption or long run average consumption.
 Permanent consumption is the planned or expected consumption.

 Transitory consumption is unplanned or unexpected consumption.

 The sum of these two components is known as actual or measured consumption by the person in the
given period of time

Ex.
8000 = 5000 + 3000
Where, 8000 is consumption expenditure in year 2019, 5000 is permanent consumption and 3000 is
transitory consumption.
 ASSUMPTION OF PIH
 Consumers are highly rationale. There objective is to maximize life time utility.

 Transitory income can be positive, negative or zero. It is a randomly distributed variable. It mean is zero

=0
 Transitory consumption can be positive, negative or zero. It is a randomly distributed variable. It mean is zero

=0
 No correlation between permanent and transitory component of the income.

 No correlation between permanent and transitory component of the consumption

 No correlation between transitory income and transitory consumption

STATEMENTS OF THE PIH
C = f ()

= k

= iW

W=

C= +

Y= +
 = k

K= APC (proportionality co-efficient between permanent

income and permanent consumption)

K = f(T, i, WH,WNH u)
Where, T = taste and preferences, i = rate of interest, W = proportion of human and non human
wealth in total wealth, u = variability of expected income.

Friedman analysed the consumption function for the non war years between 1905 and 1915. he
found
= 0.88
 Measurement of
Y= +
= iW
W=
Where, W = wealth and i = rate of interest
W = Human wealth + Non human wealth

Friedman argued can be computed from current income and past income (adaptive expectations)

is weighted average of current and past measured income, where weights decline exponentially.
= + (1- ) + +………..+ +

= 0.33

= 0.33 + 0.22 + 0.148 +………..+ + 0.001

Friedman has not clarified the number of past years to be considered.

 RECONCILIATION OF EMPIRICAL EVIDENCES BY PIH
(CONSUMPTION PUZZLE)

 Cross sectional (data of house holds) shows:

a) APC falls as Y increases
b) APC > MPC
 Cyclical data or short run data shows:
a) APC in expansion < average APC
b) APC in contraction > average APC
c) So, APC > MPC as income fluctuates
 Long run data or trend data shows:
a) APC remains constant as income increases over the long period of time
b) APC = MPC
CROSS SECTIONAL (DATA OF HOUSE HOLDS) BUDGET STUDIES

X
APC falls as Y increases

consumption C

Yt = -tive Yt = 0 Yt = +tive
Ym < Yp Ym = Yp Ym > Yp
APCt > APC APCt = APC APCt < APC

income
CYCLICAL DATA OR SHORT RUN DATA STUDIES:

APC falls as Y increases

Consumption / income

APC increases as Y falls

APC APC

> <

>0 <0

Time Y*
 LONG RUN DATA OR TREND DATA STUDIES:

X APC remains
constant as
 According to PIH income changes
 K or APC depends on various factors in the long run
K = f ( T, i, WH, WNH, U )
C

consumption
 These factors has changed in mutually cancelled
manner.
 Study of data shows that, the underlined factors have
changed in such a way that APC has remained constant.

O
income Y
CRITICAL ASSESSMENT

 Role of liquidity constraint ignored

 The concept of permanent income is not very clear

 Calculation of permanent income is complicated

 Friedman never explains why K falls when Yp increases

 Assumption of non correlation between Yt and Ct

 Role of current measured income in consumption totally ignored

 Empirical testing of the theory is difficult.

 REFERENCES

 Branson, W. H. (1989). Macro Economic Theory and Policy (3rd ed.). Harper Collins.
 Friedman, Milton (1957) : The theory of consumption function; Chapter III-The permanent income
hypothesis; Princeton University Press; http://www.nber.org/books/frie57-1
 Mankiw G, N: Macroeconomics (7th ed.), Worth publishers
 Rana, K.C and Verma, K.N: Macro Economic Analysis (11th ed.),Vishal Publishing Co.
 K Y OU
T H A N