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Permanent Income Hypothesis: Definition, How It Works, and Impact

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Investopedia / Jiaqi Zhou

What Is the Permanent Income Hypothesis?

The permanent income hypothesis is a theory of consumer spending stating that people will spend money at a level consistent with their expected long-term average income . The level of expected long-term income then becomes thought of as the level of “permanent” income that can be safely spent. A worker will save only if their current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.

Key Takeaways

• The permanent income hypothesis states that individuals will spend money at a level that is consistent with their expected long-term average income.
• Milton Friedman developed the permanent income hypothesis, believing that consumer spending is a result of estimated future income as opposed to consumption that is based on current after-tax income.
• Under the theory, if economic policies result in increased income, it will not necessarily translate into increased consumer spending.
• An individual's liquidity is a factor in their management of income and spending.

Understanding the Permanent Income Hypothesis

The permanent income hypothesis was formulated by the Nobel Prize-winning economist  Milton Friedman  in 1957. The hypothesis implies that changes in consumption behavior are not predictable because they are based on individual expectations. This has broad implications concerning economic policy.

Under this theory, even if economic policies are successful in increasing income in the economy, the policies may not kick off a multiplier effect in regards to increased consumer spending. Rather, the theory predicts that there will not be an uptick in consumer spending until workers reform expectations about their future incomes.

Milton believed that people will consume based on an estimate of their future income as opposed to what Keynesian economics proposed; people will consume based on their in the moment after-tax income. Milton's basis was that individuals prefer to smooth their consumption rather than let it bounce around as a result of short-term fluctuations in income.

Spending Habits Under the Permanent Income Hypothesis

If a worker is aware that they are likely to receive an income bonus at the end of a particular pay period, it is plausible that the worker’s spending in advance of that bonus may change in anticipation of the additional earnings. However, it is also possible that workers may choose to not increase their spending based solely on a short-term windfall. They may instead make efforts to increase their savings, based on the expected boost in income.

Something similar can be said of individuals who are informed that they are to receive an inheritance . Their personal expenditures could change to take advantage of the anticipated influx of funds, but per this theory, they may maintain their current spending levels in order to save the supplemental assets. Or, they may seek to invest those supplemental funds to provide long-term growth of their money rather than spend it immediately on disposable products and services.

Liquidity and the Permanent Income Hypothesis

The liquidity of the individual can play a role in future income expectations. Individuals with no assets may already be in the habit of spending without regard to their income; current or future.

Changes over time, however—through incremental salary raises or the assumption of new long-term jobs that bring higher, sustained pay—can lead to changes in permanent income. With their expectations elevated, employees may allow their expenditures to scale up in turn.

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13.1 Determining the Level of Consumption

Learning objectives.

• Explain and graph the consumption function and the saving function, explain what the slopes of these curves represent, and explain how the two are related to each other.
• Compare the current income hypothesis with the permanent income hypothesis, and use each to predict the effect that temporary versus permanent changes in income will have on consumption.
• Discuss two factors that can cause the consumption function to shift upward or downward.

J. R. McCulloch, an economist of the early nineteenth century, wrote, “Consumption … is, in fact, the object of industry” (Mc Culloch, 1824). Goods and services are produced so that people can use them. The factors that determine consumption thus determine how successful an economy is in fulfilling its ultimate purpose: providing goods and services for people. So, consumption is not just important because it is such a large component of economic activity. It is important because, as McCulloch said, consumption is at the heart of the economy’s fundamental purpose.

Consumption and Disposable Personal Income

It seems reasonable to expect that consumption spending by households will be closely related to their disposable personal income, which equals the income households receive less the taxes they pay. Note that disposable personal income and GDP are not the same thing. GDP is a measure of total income; disposable personal income is the income households have available to spend during a specified period.

Real values of disposable personal income and consumption per year from 1960 through 2011 are plotted in Figure 13.1 “The Relationship between Consumption and Disposable Personal Income, 1960–2011” . The data suggest that consumption generally changes in the same direction as does disposable personal income.

The relationship between consumption and disposable personal income is called the consumption function . It can be represented algebraically as an equation, as a schedule in a table, or as a curve on a graph.

Figure 13.1 The Relationship between Consumption and Disposable Personal Income, 1960–2011

Plots of consumption and disposable personal income over time suggest that consumption increases as disposable personal income increases.

Source : U. S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables 1.1.6 and 2.1 (revised February 29, 2012).

Figure 13.2 “Plotting a Consumption Function” illustrates the consumption function. The relationship between consumption and disposable personal income that we encountered in Figure 13.1 “The Relationship between Consumption and Disposable Personal Income, 1960–2011” is evident in the table and in the curve: consumption in any period increases as disposable personal income increases in that period. The slope of the consumption function tells us by how much. Consider points C and D. When disposable personal income ( Y d ) rises by $500 billion, consumption rises by $400 billion. More generally, the slope equals the change in consumption divided by the change in disposable personal income. The ratio of the change in consumption (ΔC) to the change in disposable personal income (Δ Y d ) is the marginal propensity to consume ( MPC ). The Greek letter delta (Δ) is used to denote “change in.”

Equation 13.1

In this case, the marginal propensity to consume equals $400/$500 = 0.8. It can be interpreted as the fraction of an extra $1 of disposable personal income that people spend on consumption. Thus, if a person with an MPC of 0.8 received an extra $1,000 of disposable personal income, that person’s consumption would rise by $0.80 for each extra $1 of disposable personal income, or $800.

We can also express the consumption function as an equation

Equation 13.2

Figure 13.2 Plotting a Consumption Function

The consumption function relates consumption C to disposable personal income Y d . The equation for the consumption function shown here in tabular and graphical form is C = $300 billion + 0.8 Y d .

It is important to note carefully the definition of the marginal propensity to consume. It is the change in consumption divided by the change in disposable personal income. It is not the level of consumption divided by the level of disposable personal income. Using Equation 13.2 , at a level of disposable personal income of $500 billion, for example, the level of consumption will be $700 billion so that the ratio of consumption to disposable personal income will be 1.4, while the marginal propensity to consume remains 0.8. The marginal propensity to consume is, as its name implies, a marginal concept. It tells us what will happen to an additional dollar of personal disposable income.

Notice from the curve in Figure 13.2 “Plotting a Consumption Function” that when disposable personal income equals 0, consumption is $300 billion. The vertical intercept of the consumption function is thus $300 billion. Then, for every $500 billion increase in disposable personal income, consumption rises by $400 billion. Because the consumption function in our example is linear, its slope is the same between any two points. In this case, the slope of the consumption function, which is the same as the marginal propensity to consume, is 0.8 all along its length.

We can use the consumption function to show the relationship between personal saving and disposable personal income. Personal saving is disposable personal income not spent on consumption during a particular period; the value of personal saving for any period is found by subtracting consumption from disposable personal income for that period:

Equation 13.3

The saving function relates personal saving in any period to disposable personal income in that period. Personal saving is not the only form of saving—firms and government agencies may save as well. In this chapter, however, our focus is on the choice households make between using disposable personal income for consumption or for personal saving.

Figure 13.3 “Consumption and Personal Saving” shows how the consumption function and the saving function are related. Personal saving is calculated by subtracting values for consumption from values for disposable personal income, as shown in the table. The values for personal saving are then plotted in the graph. Notice that a 45-degree line has been added to the graph. At every point on the 45-degree line, the value on the vertical axis equals that on the horizontal axis. The consumption function intersects the 45-degree line at an income of $1,500 billion (point D). At this point, consumption equals disposable personal income and personal saving equals 0 (point D′ on the graph of personal saving). Using the graph to find personal saving at other levels of disposable personal income, we subtract the value of consumption, given by the consumption function, from disposable personal income, given by the 45-degree line.

Figure 13.3 Consumption and Personal Saving

Personal saving equals disposable personal income minus consumption. The table gives hypothetical values for these variables. The consumption function is plotted in the upper part of the graph. At points along the 45-degree line, the values on the two axes are equal; we can measure personal saving as the distance between the 45-degree line and consumption. The curve of the saving function is in the lower portion of the graph.

At a disposable personal income of $2,000 billion, for example, consumption is $1,900 billion (point E). Personal saving equals $100 billion (point E′)—the vertical distance between the 45-degree line and the consumption function. At an income of $500 billion, consumption totals $700 billion (point B). The consumption function lies above the 45-degree line at this point; personal saving is −$200 billion (point B′). A negative value for saving means that consumption exceeds disposable personal income; it must have come from saving accumulated in the past, from selling assets, or from borrowing.

Notice that for every $500 billion increase in disposable personal income, personal saving rises by $100 billion. Consider points C′ and D′ in Figure 13.3 “Consumption and Personal Saving” . When disposable personal income rises by $500 billion, personal saving rises by $100 billion. More generally, the slope of the saving function equals the change in personal saving divided by the change in disposable personal income. The ratio of the change in personal saving (Δ S ) to the change in disposable personal income (Δ Y d ) is the marginal propensity to save ( MPS ).

Equation 13.4

In this case, the marginal propensity to save equals $100/$500 = 0.2. It can be interpreted as the fraction of an extra $1 of disposable personal income that people save. Thus, if a person with an MPS of 0.2 received an extra $1,000 of disposable personal income, that person’s saving would rise by $0.20 for each extra $1 of disposable personal income, or $200. Since people have only two choices of what to do with additional disposable personal income—that is, they can use it either for consumption or for personal saving—the fraction of disposable personal income that people consume ( MPC ) plus the fraction of disposable personal income that people save ( MPS ) must add to 1:

Equation 13.5

Current versus Permanent Income

The discussion so far has related consumption in a particular period to income in that same period. The current income hypothesis holds that consumption in any one period depends on income during that period, or current income.

Although it seems obvious that consumption should be related to disposable personal income, it is not so obvious that consumers base their consumption in any one period on the income they receive during that period. In buying a new car, for example, consumers might base their decision not only on their current income but on the income they expect to receive during the three or four years they expect to be making payments on the car. Parents who purchase a college education for their children might base their decision on their own expected lifetime income.

Indeed, it seems likely that virtually all consumption choices could be affected by expectations of income over a very long period. One reason people save is to provide funds to live on during their retirement years. Another is to build an estate they can leave to their heirs through bequests. The amount people save for their retirement or for bequests depends on the income they expect to receive for the rest of their lives. For these and other reasons, then, personal saving (and thus consumption) in any one year is influenced by permanent income. Permanent income is the average annual income people expect to receive for the rest of their lives.

People who have the same current income but different permanent incomes might reach very different saving decisions. Someone with a relatively low current income but a high permanent income (a college student planning to go to medical school, for example) might save little or nothing now, expecting to save for retirement and for bequests later. A person with the same low income but no expectation of higher income later might try to save some money now to provide for retirement or bequests later. Because a decision to save a certain amount determines how much will be available for consumption, consumption decisions can also be affected by expected lifetime income. Thus, an alternative approach to explaining consumption behavior is the permanent income hypothesis , which assumes that consumption in any period depends on permanent income. An important implication of the permanent income hypothesis is that a change in income regarded as temporary will not affect consumption much, since it will have little effect on average lifetime income; a change regarded as permanent will have an effect. The current income hypothesis, though, predicts that it does not matter whether consumers view a change in disposable personal income as permanent or temporary; they will move along the consumption function and change consumption accordingly.

The question of whether permanent or current income is a determinant of consumption arose in 1992 when President George H. W. Bush ordered a change in the withholding rate for personal income taxes. Workers have a fraction of their paychecks withheld for taxes each pay period; Mr. Bush directed that this fraction be reduced in 1992. The change in the withholding rate did not change income tax rates; by withholding less in 1992, taxpayers would either receive smaller refund checks in 1993 or owe more taxes. The change thus left taxpayers’ permanent income unaffected.

President Bush’s measure was designed to increase aggregate demand and close the recessionary gap created by the 1990–1991 recession. Economists who subscribed to the permanent income hypothesis predicted that the change would not have any effect on consumption. Those who subscribed to the current income hypothesis predicted that the measure would boost consumption substantially in 1992. A survey of households taken during this period suggested that households planned to spend about 43% of the temporary increase in disposable personal income produced by the withholding experiment (Shapiro & SLemrod, 1995). That is considerably less than would be predicted by the current income hypothesis, but more than the zero change predicted by the permanent income hypothesis. This result, together with related evidence, suggests that temporary changes in income can affect consumption, but that changes regarded as permanent will have a much stronger impact.

Many of the tax cuts passed during the administration of President George W. Bush are set to expire at the end of 2012. The proposal to make these tax cuts permanent is aimed toward having a stronger impact on consumption, since tax cuts regarded as permanent have larger effects than do changes regarded as temporary.

Other Determinants of Consumption

The consumption function graphed in Figure 13.2 “Plotting a Consumption Function” and Figure 13.3 “Consumption and Personal Saving” relates consumption spending to the level of disposable personal income. Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of changes that could shift the consumption function are changes in real wealth and changes in expectations. Figure 13.4 “Shifts in the Consumption Function” illustrates how these changes can cause shifts in the curve.

Figure 13.4 Shifts in the Consumption Function

An increase in the level of consumption at each level of disposable personal income shifts the consumption function upward in Panel (a). Among the events that would shift the curve upward are an increase in real wealth and an increase in consumer confidence. A reduction in the level of consumption at each level of disposable personal income shifts the curve downward in Panel (b). The events that could shift the curve downward include a reduction in real wealth and a decline in consumer confidence.

Changes in Real Wealth

An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption. An increase in real wealth shifts the consumption function upward, as illustrated in Panel (a) of Figure 13.4 “Shifts in the Consumption Function” . A reduction in real wealth shifts it downward, as shown in Panel (b).

A change in the price level changes real wealth. We learned in an earlier chapter that the relationship among the price level, real wealth, and consumption is called the wealth effect . A reduction in the price level increases real wealth and shifts the consumption function upward, as shown in Panel (a). An increase in the price level shifts the curve downward, as shown in Panel (b).

Changes in Expectations

Consumers are likely to be more willing to spend money when they are optimistic about the future. Surveyors attempt to gauge this optimism using “consumer confidence” surveys that ask respondents to report whether they are optimistic or pessimistic about their own economic situation and about the prospects for the economy as a whole. An increase in consumer optimism tends to shift the consumption function upward as in Panel (a) of Figure 13.4 “Shifts in the Consumption Function” ; an increase in pessimism tends to shift it downward as in Panel (b). The sharp reduction in consumer confidence in 2008 and early in 2009 contributed to a downward shift in the consumption function and thus to the severity of the recession.

The relationship between consumption and consumer expectations concerning future economic conditions tends to be a form of self-fulfilling prophecy. If consumers expect economic conditions to worsen, they will cut their consumption—and economic conditions will worsen! Political leaders often try to persuade people that economic prospects are good. In part, such efforts are an attempt to increase economic activity by boosting consumption.

Key Takeaways

• Consumption is closely related to disposable personal income and is represented by the consumption function, which can be presented in a table, in a graph, or in an equation.
• Personal saving is disposable personal income not spent on consumption.
• The marginal propensity to consume is MPC = Δ C /Δ Y d and the marginal propensity to save is MPS = Δ S /Δ Y d . The sum of the MPC and MPS is 1.
• The current income hypothesis holds that consumption is a function of current disposable personal income, whereas the permanent income hypothesis holds that consumption is a function of permanent income, which is the income households expect to receive annually during their lifetime. The permanent income hypothesis predicts that a temporary change in income will have a smaller effect on consumption than is predicted by the current income hypothesis.
• Other factors that affect consumption include real wealth and expectations.

For each of the following events, draw a curve representing the consumption function and show how the event would affect the curve.

• A sharp increase in stock prices increases the real wealth of most households.
• Consumers decide that a recession is ahead and that their incomes are likely to fall.
• The price level falls.

Case in Point: Consumption and the Tax Rebate of 2001

Images Money – Tax Rebate – CC BY 2.0.

The first round of the Bush tax cuts was passed in 2001. Democrats in Congress insisted on a rebate aimed at stimulating consumption. In the summer of 2001, rebates of $300 per single taxpayer and of $600 for married couples were distributed. The Department of Treasury reported that 92 million people received the rebates. While the rebates were intended to stimulate consumption, the extent to which the tax rebates stimulated consumption, especially during the recession, is an empirical question.

It is difficult to analyze the impact of a tax rebate that is a single event experienced by all households at the same time. If spending does change at that moment, is it because of the tax rebate or because of some other event that occurred at that time?

Fortunately for researchers Sumit Agarwal, Chunlin Liu, and Nicholas Souleles, using data from credit card accounts, the 2001 tax rebate checks were distributed over 10 successive weeks from July to September of 2001. The timing of receipt was random, since it was based on the next-to-last digit of one’s Social Security number, and taxpayers were informed well in advance that the checks were coming. The researchers found that consumers initially saved much of their rebates, by paying down their credit card debts, but over a nine-month period, spending increased to about 40% of the rebate. They also found that consumers who were most liquidity constrained (for example, close to their credit card debt limits) spent more than consumers who were less constrained.

The researchers thus conclude that their findings do not support the permanent income hypothesis, since consumers responded to spending based on when they received their checks and because the results indicate that consumers do respond to what they call “lumpy” changes in income, such as those generated by a tax rebate. In other words, current income does seem to matter.

Two other studies of the 2001 tax rebate reached somewhat different conclusions. Using survey data, researchers Matthew D. Shapiro and Joel Slemrod estimated an MPC of about one-third. They note that this low increased spending is particularly surprising, since the rebate was part of a general tax cut that was expected to last a long time. At the other end, David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, using yet another data set, found that looking over a six-month period, the MPC was about two-thirds. So, while there is disagreement on the size of the MPC , all conclude that the impact was non-negligible.

Sources : Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, “The Reaction of Consumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit Data,” NBER Working Paper No. 13694, December 2007; David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and the Income Tax Rebates of 2001,” American Economic Review 96, no. 5 (December 2006): 1589–1610; Matthew D. Shapiro and Joel Slemrod, “Consumer Response to Tax Rebates,” American Economic Review 93, no. 1 (March 2003): 381–96; and Matthew D. Shapiro and Joel Slemrod, “Did the 2001 Rebate Stimulate Spending? Evidence from Taxpayer Surveys,” NBER Tax Policy & the Economy 17, no. 1 (2003): 83–109.

Answers to Try It! Problems

• A sharp increase in stock prices makes people wealthier and shifts the consumption function upward, as in Panel (a) of Figure 13.4 “Shifts in the Consumption Function” .
• This would be reported as a reduction in consumer confidence. Consumers are likely to respond by reducing their purchases, particularly of durable items such as cars and washing machines. The consumption function will shift downward, as in Panel (b) of Figure 13.4 “Shifts in the Consumption Function” .
• A reduction in the price level increases real wealth and thus boosts consumption. The consumption function will shift upward, as in Panel (a) of Figure 13.4 “Shifts in the Consumption Function” .

Mc Culloch, J. R., A Discourse on the Rise, Progress, Peculiar Objects, and Importance, of Political Economy: Containing the Outline of a Course of Lectures on the Principles and Doctrines of That Science (Edinburgh: Archibald Constable, 1824), 103.

Shapiro, M. D. and Joel Slemrod, “Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding,” American Economic Review 85 (March 1995): 274–83.

Principles of Macroeconomics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

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Permanent Income Hypothesis

Definition of permanent income hypothesis.

The Permanent Income Hypothesis (PIH) is an economic theory that suggests individuals’ consumption patterns are determined by their long-term average income rather than their short-term fluctuations in income. According to this hypothesis, people adjust their consumption based on their expectations of future income rather than their current income level.

To illustrate the Permanent Income Hypothesis, consider two individuals: Alice and Bob. Alice is a salaried employee who earns a consistent income every month, while Bob is self-employed and experiences fluctuations in his income from month to month.

Alice, who has a stable income, consistently spends a portion of her income on necessities, such as rent, groceries, and utility bills. She also saves a portion for future expenses and retirement. Even if Alice’s income increases or decreases slightly from month to month, her overall consumption and saving habits remain relatively stable because her long-term average income remains constant.

On the other hand, Bob’s income is more volatile as a self-employed individual. When Bob has a month with high earnings, he spends more on luxury items and experiences. However, during months with lower income, he reduces his discretionary spending to compensate for the decrease in earnings.

This example demonstrates how individuals with different income patterns respond differently to changes in income. Alice’s consumption is more closely linked to her long-term average income, while Bob’s consumption fluctuates with his short-term income.

Why the Permanent Income Hypothesis Matters

The Permanent Income Hypothesis has important implications for economic policy and the understanding of consumer behavior. If the hypothesis holds true, it suggests that policies aimed at stimulating short-term consumption, such as temporary tax cuts or government transfers, may have limited long-term effects. Instead, policies that focus on promoting long-term income growth, such as investments in education and infrastructure, may have a more significant impact on consumption and economic well-being.

Understanding the Permanent Income Hypothesis also helps to explain why individuals may be hesitant to significantly increase their consumption even when their current income rises temporarily, such as receiving a year-end bonus. Instead, they may choose to save or invest the extra income, anticipating future fluctuations or planning for long-term goals.

Overall, the Permanent Income Hypothesis provides a framework for analyzing patterns of consumption and saving behavior, allowing economists and policymakers to make more informed decisions regarding income inequality, social welfare programs, and economic stability.

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5.1 The Permanent Income Hypothesis

The Permanent Income Hypothesis (PIH) attempts to explain consumption behavior and expected relationships in cross-sectional and longitudinal APC's by first redefining measures of income.

Observed values of aggregate income 'Y' can be divided up into two separate components: 'Y P ' Permanent (or projected levels of) Income and 'Y T ' Transitory (or unexpected changes in) Income. Thus:

Y = Y P + Y T .

The transitory component has an expected value of zero (E[Y T t ] = 0) reflecting the notion that over time transitory gains are offset by future transitory losses and vice-versa. Thus in the long run observed levels of income 'Y' are equal to permanent income 'Y P '.

Finally, according to the PIH consumption expenditure is proportional to permanent income:

such that the parameter ' k ', a constant, represents both the average propensity to consume and the marginal propensity to consume . This consumption function (as shown with the blue line below) is described more accurately as a long run consumption function consistent with the observed long run results of consumption behavior.

Observed short run behavior is explained through the value of transitory income for different income groups. Specifically, transitory income for low income groups is assumed to be negative reflecting the notion that over time transitory losses exceed transitory gains for this group of individuals:

Y T L < 0 → Y L < Y P L

For middle income groups the value of transitory income is equal to zero over time such that observed and permanent income take the same value:

Y T M = 0 → Y M = Y P M

Finally, for high income groups, transitory gains exceed transitory losses such that transitory income is on average positive over time or:

Y T H > 0 → Y H > Y P H

The impact of this transitory component can be used to develop a short run consumption function (the red line) as shown in the diagram.

The PIH provides a framework for understanding how households will likely react to changes in income in making near-term consumption spending decisions. If the changes in income are perceived to be transitory, consumption spending may be unaffected -- transitory gains will be saved to meet the demands of transitory losses sometime in the future. Changes in income that are perceived to be permanent can have a real and immediate impact on consumption spending.

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7.1: Determining the Level of Consumption

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Learning Objective

• Explain and graph the consumption function and the saving function, explain what the slopes of these curves represent, and explain how the two are related to each other.
• Compare the current income hypothesis with the permanent income hypothesis, and use each to predict the effect that temporary versus permanent changes in income will have on consumption.
• Discuss two factors that can cause the consumption function to shift upward or downward.

J. R. McCulloch, an economist of the early nineteenth century, wrote, “Consumption … is, in fact, the object of industry” (Mc Culloch, 1824). Goods and services are produced so that people can use them. The factors that determine consumption thus determine how successful an economy is in fulfilling its ultimate purpose: providing goods and services for people. So, consumption is not just important because it is such a large component of economic activity. It is important because, as McCulloch said, consumption is at the heart of the economy’s fundamental purpose.

Consumption and Disposable Personal Income

It seems reasonable to expect that consumption spending by households will be closely related to their disposable personal income, which equals the income households receive less the taxes they pay. Note that disposable personal income and GDP are not the same thing. GDP is a measure of total income; disposable personal income is the income households have available to spend during a specified period.

Real values of disposable personal income and consumption per year from 1960 through 2010 are plotted in Figure 28.1. The data suggest that consumption generally changes in the same direction as does disposable personal income.

The relationship between consumption and disposable personal income is called the consumption function . It can be represented algebraically as an equation, as a schedule in a table, or as a curve on a graph.

Source : U. S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables 1.16 and 2.1 (November 23, 2010 revision; Data are through 3rd quarter 2010).

Figure 28.2 illustrates the consumption function. The relationship between consumption and disposable personal income that we encountered in Figure 28.1 is evident in the table and in the curve: consumption in any period increases as disposable personal income increases in that period. The slope of the consumption function tells us by how much. Consider points C and D. When disposable personal income ( Y d ) rises by $500 billion, consumption rises by $400 billion. More generally, the slope equals the change in consumption divided by the change in disposable personal income. The ratio of the change in consumption (ΔC) to the change in disposable personal income (Δ Y d ) is the marginal propensity to consume ( MPC ). The Greek letter delta (Δ) is used to denote “change in.”

Equation 28.1

In this case, the marginal propensity to consume equals $400/$500 = 0.8. It can be interpreted as the fraction of an extra $1 of disposable personal income that people spend on consumption. Thus, if a person with an MPC of 0.8 received an extra $1,000 of disposable personal income, that person’s consumption would rise by $0.80 for each extra $1 of disposable personal income, or $800.

We can also express the consumption function as an equation

Equation 28.2

It is important to note carefully the definition of the marginal propensity to consume. It is the change in consumption divided by the change in disposable personal income. It is not the level of consumption divided by the level of disposable personal income. Using Equation 28.2 , at a level of disposable personal income of $500 billion, for example, the level of consumption will be $700 billion so that the ratio of consumption to disposable personal income will be 1.4, while the marginal propensity to consume remains 0.8. The marginal propensity to consume is, as its name implies, a marginal concept. It tells us what will happen to an additional dollar of personal disposable income.

Notice from the curve in Figure 28.2 that when disposable personal income equals 0, consumption is $300 billion. The vertical intercept of the consumption function is thus $300 billion. Then, for every $500 billion increase in disposable personal income, consumption rises by $400 billion. Because the consumption function in our example is linear, its slope is the same between any two points. In this case, the slope of the consumption function, which is the same as the marginal propensity to consume, is 0.8 all along its length.

We can use the consumption function to show the relationship between personal saving and disposable personal income. Personal saving is disposable personal income not spent on consumption during a particular period; the value of personal saving for any period is found by subtracting consumption from disposable personal income for that period:

Equation 28.3

The saving function relates personal saving in any period to disposable personal income in that period. Personal saving is not the only form of saving—firms and government agencies may save as well. In this chapter, however, our focus is on the choice households make between using disposable personal income for consumption or for personal saving.

Figure 28.3 shows how the consumption function and the saving function are related. Personal saving is calculated by subtracting values for consumption from values for disposable personal income, as shown in the table. The values for personal saving are then plotted in the graph. Notice that a 45-degree line has been added to the graph. At every point on the 45-degree line, the value on the vertical axis equals that on the horizontal axis. The consumption function intersects the 45-degree line at an income of $1,500 billion (point D). At this point, consumption equals disposable personal income and personal saving equals 0 (point D′ on the graph of personal saving). Using the graph to find personal saving at other levels of disposable personal income, we subtract the value of consumption, given by the consumption function, from disposable personal income, given by the 45-degree line.

At a disposable personal income of $2,000 billion, for example, consumption is $1,900 billion (point E). Personal saving equals $100 billion (point E′)—the vertical distance between the 45-degree line and the consumption function. At an income of $500 billion, consumption totals $700 billion (point B). The consumption function lies above the 45-degree line at this point; personal saving is −$200 billion (point B′). A negative value for saving means that consumption exceeds disposable personal income; it must have come from saving accumulated in the past, from selling assets, or from borrowing.

Notice that for every $500 billion increase in disposable personal income, personal saving rises by $100 billion. Consider points C′ and D′ in Figure 28.3. When disposable personal income rises by $500 billion, personal saving rises by $100 billion. More generally, the slope of the saving function equals the change in personal saving divided by the change in disposable personal income. The ratio of the change in personal saving (Δ S ) to the change in disposable personal income (Δ Y d ) is the marginal propensity to save ( MPS ).

Equation 28.4

In this case, the marginal propensity to save equals $100/$500 = 0.2. It can be interpreted as the fraction of an extra $1 of disposable personal income that people save. Thus, if a person with an MPS of 0.2 received an extra $1,000 of disposable personal income, that person’s saving would rise by $0.20 for each extra $1 of disposable personal income, or $200. Since people have only two choices of what to do with additional disposable personal income—that is, they can use it either for consumption or for personal saving—the fraction of disposable personal income that people consume ( MPC ) plus the fraction of disposable personal income that people save ( MPS ) must add to 1:

Equation 28.5

Current versus Permanent Income

The discussion so far has related consumption in a particular period to income in that same period. The current income hypothesis holds that consumption in any one period depends on income during that period, or current income.

Although it seems obvious that consumption should be related to disposable personal income, it is not so obvious that consumers base their consumption in any one period on the income they receive during that period. In buying a new car, for example, consumers might base their decision not only on their current income but on the income they expect to receive during the three or four years they expect to be making payments on the car. Parents who purchase a college education for their children might base their decision on their own expected lifetime income.

Indeed, it seems likely that virtually all consumption choices could be affected by expectations of income over a very long period. One reason people save is to provide funds to live on during their retirement years. Another is to build an estate they can leave to their heirs through bequests. The amount people save for their retirement or for bequests depends on the income they expect to receive for the rest of their lives. For these and other reasons, then, personal saving (and thus consumption) in any one year is influenced by permanent income. Permanent income is the average annual income people expect to receive for the rest of their lives.

People who have the same current income but different permanent incomes might reach very different saving decisions. Someone with a relatively low current income but a high permanent income (a college student planning to go to medical school, for example) might save little or nothing now, expecting to save for retirement and for bequests later. A person with the same low income but no expectation of higher income later might try to save some money now to provide for retirement or bequests later. Because a decision to save a certain amount determines how much will be available for consumption, consumption decisions can also be affected by expected lifetime income. Thus, an alternative approach to explaining consumption behavior is the permanent income hypothesis , which assumes that consumption in any period depends on permanent income. An important implication of the permanent income hypothesis is that a change in income regarded as temporary will not affect consumption much, since it will have little effect on average lifetime income; a change regarded as permanent will have an effect. The current income hypothesis, though, predicts that it does not matter whether consumers view a change in disposable personal income as permanent or temporary; they will move along the consumption function and change consumption accordingly.

The question of whether permanent or current income is a determinant of consumption arose in 1992 when President George H. W. Bush ordered a change in the withholding rate for personal income taxes. Workers have a fraction of their paychecks withheld for taxes each pay period; Mr. Bush directed that this fraction be reduced in 1992. The change in the withholding rate did not change income tax rates; by withholding less in 1992, taxpayers would either receive smaller refund checks in 1993 or owe more taxes. The change thus left taxpayers’ permanent income unaffected.

President Bush’s measure was designed to increase aggregate demand and close the recessionary gap created by the 1990–1991 recession. Economists who subscribed to the permanent income hypothesis predicted that the change would not have any effect on consumption. Those who subscribed to the current income hypothesis predicted that the measure would boost consumption substantially in 1992. A survey of households taken during this period suggested that households planned to spend about 43% of the temporary increase in disposable personal income produced by the withholding experiment (Shapiro & Slemrod, 1995). That is considerably less than would be predicted by the current income hypothesis, but more than the zero change predicted by the permanent income hypothesis. This result, together with related evidence, suggests that temporary changes in income can affect consumption, but that changes regarded as permanent will have a much stronger impact.

Many of the tax cuts passed during the administration of President George W. Bush are set to expire in 2010. The proposal to make these tax cuts permanent is aimed toward having a stronger impact on consumption, since tax cuts regarded as permanent have larger effects than do changes regarded as temporary.

Other Determinants of Consumption

The consumption function graphed in Figure 28.2 and Figure 28.3 relates consumption spending to the level of disposable personal income. Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of changes that could shift the consumption function are changes in real wealth and changes in expectations. Figure 28.4 illustrates how these changes can cause shifts in the curve.

Changes in Real Wealth

An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption. An increase in real wealth shifts the consumption function upward, as illustrated in Panel (a) of Figure 28.4. A reduction in real wealth shifts it downward, as shown in Panel (b).

A change in the price level changes real wealth. We learned in an earlier chapter that the relationship among the price level, real wealth, and consumption is called the wealth effect . A reduction in the price level increases real wealth and shifts the consumption function upward, as shown in Panel (a). An increase in the price level shifts the curve downward, as shown in Panel (b).

Changes in Expectations

Consumers are likely to be more willing to spend money when they are optimistic about the future. Surveyors attempt to gauge this optimism using “consumer confidence” surveys that ask respondents to report whether they are optimistic or pessimistic about their own economic situation and about the prospects for the economy as a whole. An increase in consumer optimism tends to shift the consumption function upward as in Panel (a) of Figure 28.4; an increase in pessimism tends to shift it downward as in Panel (b). The sharp reduction in consumer confidence in 2008 and early in 2009 contributed to a downward shift in the consumption function and thus to the severity of the recession.

The relationship between consumption and consumer expectations concerning future economic conditions tends to be a form of self-fulfilling prophecy. If consumers expect economic conditions to worsen, they will cut their consumption—and economic conditions will worsen! Political leaders often try to persuade people that economic prospects are good. In part, such efforts are an attempt to increase economic activity by boosting consumption.

Key Takeaways

• Consumption is closely related to disposable personal income and is represented by the consumption function, which can be presented in a table, in a graph, or in an equation.
• Personal saving is disposable personal income not spent on consumption.
• The marginal propensity to consume is MPC = Δ C /Δ Y d and the marginal propensity to save is MPS = Δ S /Δ Y d . The sum of the MPC and MPS is 1.
• The current income hypothesis holds that consumption is a function of current disposable personal income, whereas the permanent income hypothesis holds that consumption is a function of permanent income, which is the income households expect to receive annually during their lifetime. The permanent income hypothesis predicts that a temporary change in income will have a smaller effect on consumption than is predicted by the current income hypothesis.
• Other factors that affect consumption include real wealth and expectations.

For each of the following events, draw a curve representing the consumption function and show how the event would affect the curve.

• A sharp increase in stock prices increases the real wealth of most households.
• Consumers decide that a recession is ahead and that their incomes are likely to fall.
• The price level falls.

Case in Point: Consumption and the Tax Rebate of 2001

Figure 28.5

Max Wei – Cashier – CC BY-ND 2.0.

The first round of the Bush tax cuts was passed in 2001. Democrats in Congress insisted on a rebate aimed at stimulating consumption. In the summer of 2001, rebates of $300 per single taxpayer and of $600 for married couples were distributed. The Department of Treasury reported that 92 million people received the rebates. While the rebates were intended to stimulate consumption, the extent to which the tax rebates stimulated consumption, especially during the recession, is an empirical question.

It is difficult to analyze the impact of a tax rebate that is a single event experienced by all households at the same time. If spending does change at that moment, is it because of the tax rebate or because of some other event that occurred at that time?

Fortunately for researchers Sumit Agarwal, Chunlin Liu, and Nicholas Souleles, using data from credit card accounts, the 2001 tax rebate checks were distributed over 10 successive weeks from July to September of 2001. The timing of receipt was random, since it was based on the next-to-last digit of one’s Social Security number, and taxpayers were informed well in advance that the checks were coming. The researchers found that consumers initially saved much of their rebates, by paying down their credit card debts, but over a nine-month period, spending increased to about 40% of the rebate. They also found that consumers who were most liquidity constrained (for example, close to their credit card debt limits) spent more than consumers who were less constrained.

The researchers thus conclude that their findings do not support the permanent income hypothesis, since consumers responded to spending based on when they received their checks and because the results indicate that consumers do respond to what they call “lumpy” changes in income, such as those generated by a tax rebate. In other words, current income does seem to matter.

Two other studies of the 2001 tax rebate reached somewhat different conclusions. Using survey data, researchers Matthew D. Shapiro and Joel Slemrod estimated an MPC of about one-third. They note that this low increased spending is particularly surprising, since the rebate was part of a general tax cut that was expected to last a long time. At the other end, David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, using yet another data set, found that looking over a six-month period, the MPC was about two-thirds. So, while there is disagreement on the size of the MPC , all conclude that the impact was non-negligible.

Sources : Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, “The Reaction of Consumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit Data,” NBER Working Paper No. 13694, December 2007; David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and the Income Tax Rebates of 2001,” American Economic Review 96, no. 5 (December 2006): 1589–1610; Matthew D. Shapiro and Joel Slemrod, “Consumer Response to Tax Rebates,” American Economic Review 93, no. 1 (March 2003): 381–96; and Matthew D. Shapiro and Joel Slemrod, “Did the 2001 Rebate Stimulate Spending? Evidence from Taxpayer Surveys,” NBER Tax Policy & the Economy 17, no. 1 (2003): 83–109.

Answers to Try It! Problems

• A sharp increase in stock prices makes people wealthier and shifts the consumption function upward, as in Panel (a) of Figure 28.4.
• This would be reported as a reduction in consumer confidence. Consumers are likely to respond by reducing their purchases, particularly of durable items such as cars and washing machines. The consumption function will shift downward, as in Panel (b) of Figure 28.4.
• A reduction in the price level increases real wealth and thus boosts consumption. The consumption function will shift upward, as in Panel (a) of Figure 28.4.

Mc Culloch, J. R., A Discourse on the Rise, Progress, Peculiar Objects, and Importance, of Political Economy: Containing the Outline of a Course of Lectures on the Principles and Doctrines of That Science (Edinburgh: Archibald Constable, 1824), 103.

Shapiro, M. D., and Joel Slemrod, “Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding,” American Economic Review 85 (March 1995): 274–83.

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Permanent-Income Hypothesis

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The permanent income hypothesis (PIH) is a theory that links an individual’s consumption at any point in time to that individual’s total income earned over their lifetime.

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Aguiar, M., Hurst, E. (2008). Permanent-Income Hypothesis. In: Durlauf, S.N., Blume, L.E. (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1007/978-1-349-58802-2_1269

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      H a l l , R o b e r t   E . (1978): “Stochastic Implications of the Life-Cycle/Permanent Income Hypothesis: Theory and Evidence,” Journal of Political Economy , 96, 971–87, Available at http://www.stanford.edu/~rehall/Stochastic-JPE-Dec-1978.pdf .

      M u t h , J o h n   F . (1960): “Optimal Properties of Exponentially Weighted Forecasts,” Journal of the American Statistical Association , 55(290), 299–306.

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Permanent Income Hypothesis: Subject-Matter, Reconciliation and Criticisms | Consumption Function

Let us make an in-depth study of the Permanent Income Hypothesis:- 1. Subject-Matter of Permanent Income Hypothesis 2. Reconciliation 3. Criticisms of the Permanent Income Hypothesis 4. Policy Implications of the Permanent Income Hypothesis.

Subject-Matter of the Permanent Income Hypothesis:

Under the relative income hypothesis, current consumption depends on current income relative to previous peak income.

Consequently, current consumption depends on more than current income.

This is also true in the case of the permanent income hypothesis developed by Milton Friedman.

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Under the permanent income hypothesis, current consumption depends on current income and anticipated future income. This view is intuitively plausible. For example, if a household receives current income which is appreciably less than it anticipates in the future, the household is likely to consume more than is suggested by the level of its current income.

Friedman’s permanent income hypothesis is based on three fundamental propositions. (I), a household’s actual income, v, and consumption, c, in a particular period may be separated into permanent and transitory components. In other words,

y=y P + y t

and c = c p + c t

where the subscripts p and t stand for permanent and transitory, respectively.

According to Friedman, permanent income is the amount a household can consume while keeping its wealth intact. By wealth, Friedman means the present value of the income expected to accrue to the household in the future. Since permanent income is, in part, based on the household’s anticipated future income, it is a long run concept.

Since permanent income depends on future income, it cannot be measured directly. In his empirical work, Friedman regards permanent income as a weighted average of current and past incomes, with the current year weighted more heavily and prior years weighted less and less heavily, it is less variable than current income.

Transitory income may be interpreted as unanticipated income; it may be either positive or negative. For example, farmers may receive more income than anticipate because of unusually good weather, or they may receive less income because exceptionally bad weather. Similarly, an individual may earn less than anticipate because of illness.

If a household’s transitory income is positive, its actual income exceeds its permanent income. On the other hand, if its transitory income is negative, the reverse is true. By its nature, transitory income is regarded as temporary.

According to Friedman, a household’s actual consumption may also be divided into permanent and transitory components. Permanent consumption is consumption determined by permanent income. Transitory consumption may be interpreted as unanticipated consumption, such as unexpected doctor bills, unusually high (or low) heating bills, and the like.

Transitory consumption, like transitory income, may be either positive or negative. If it is positive, a household’s actual consumption is greater than its permanent consumption. If it is negative, the opposite is true. Like transitory income, transitory consumption is regarded as temporary. Friedman assumes that permanent consumption is a constant proportion, n, of permanent income.

In equation form,

c p = ny p (0 < n < 1).

Although n is independent of the absolute level of permanent income, it depends on the interest rate and a number of other variables. Friedman assumes that there is no relationship between transitory and permanent income, between transitory and permanent consumption, and between transitory consumption and transitory income. The first assumption implies that transitory income is random with respect to permanent income; the second implies that transitory consumption is independent of permanent consumption.

The last assumption—that transitory consumption is random with respect to transitory income—implies that the marginal propensity to consume from transitory income is zero. This means that a household fortunate enough to receive positive transitory income will not alter its consumption (which is based on permanent income). Instead, the household will save the additional income. Similarly, if a household is unlucky enough to receive negative transitory income, it will not reduce its consumption. Rather, it will reduce its saving.

At first glance, the assumption of a zero marginal propensity to consume from transitory income appears naive, at least in the case of positive transitory income. After all, if a household receives a windfall, it seems likely that its consumption will increase. Friedman and others have argued that the purchase of durable goods should properly be regarded as investment rather than consumption.

The reasoning is that durable goods, by definition, are not consumed during the year in which they are purchased. Instead, they provide a How of services over a number of years. If only the value of services rendered per year is counted, the assumption of a zero marginal propensity to consume from transitory income is more plausible.

Based on the three propositions, a household is assumed to plan its consumption on the basis of its permanent income with permanent consumption equal to a constant proportion, n, of its permanent income. Consequently, under the permanent income hypothesis, the basic relationship between consumption and income is denoted by the long-run consumption function.

The Reconciliation :

To reconcile the short- and long-run consumption functions using the permanent income hypothesis, consider the economy over the business cycle. The nation’s output increases over time. But output does not grow at a steady rate; if often reaches a peak and then declines. These fluctuations in output and economic activity in general are called business cycles. When output is at its highest level, the business cycle is said to be at its peak. When output is at its lowest level, the business cycle is at its trough.

Since permanent income is a long-run concept, it does not vary to the same degree as actual income over the business cycle. Consequently, when the business cycle is at its peak, actual income is greater than permanent income. Since actual income is greater than permanent income, transitory income is positive.

Since the marginal propensity to consume from transitory income is zero, households do not alter their expenditure plans. Consequently, consumption is not proportional to actual income at the peak; it is less than proportional, thereby producing a point on the short-run consumption function which is below the long-run consumption function.

To illustrate, suppose Y’ in Figure 6.15 represents income at the peak of the business cycle. With permanent income less than actual income at the peak, assume that Y p represents the corresponding level of permanent income. Since consumption is determined by permanent income, consumption is C = C p ‘ at permanent income Y p’ 8 . In as much as the short-run consumption function is based on actual consumption and income, (Y’, C’) is a point on the short-run consumption function.

At the trough, the situation is reversed. Actual income is less than permanent income, negative.

Since the marginal propensity to consume from transitory income is zero, households do not reduce their consumption. Instead, they reduce their saving. As a result, consumption is more than proportional to actual income, thereby producing a point on the short-run consumption function which is above the long-run consumption function.

To illustrate, suppose Y” and Y” p represent respectively the actual and permanent levels of income at the trough. Since consumption is determined by permanent income, consumption of C” = C p ” and (Y”, C”) is another point on the short-run consumption function.

In simplest terms, the short-run consumption function, a relationship between actual consumption and actual income, exists because of deviations between actual and permanent income. Since permanent income is a long-run concept, actual income varies to a greater degree than permanent income. In as much as consumption is based on permanent income, consumption varies to a smaller degree than actual income. These smaller variations in consumption produce the relatively flat consumption function that is observed in the short run.

Criticisms of the Permanent Income Hypothesis :

Although much empirical evidence supports the permanent income hypothesis, evidence also exists which contradicts the hypothesis.

Criticism of the hypothesis has centered on two main assumptions:

(1) The assumption of a constant average propensity to consume;

(2) The assumption of a marginal propensity to consume from transitory income equal to zero.

Among others, Irwin Friend and Irving B. Kravis have objected to Friedman’s assumption of a constant average propensity to consume. They contend that households with low levels of permanent income arc under much heavier pressure to consume than households with much higher levels of permanent income.

Therefore, from a theoretical standpoint, the average propensity to consume of low-income households should exceed that of high-income households. Thus, Friend and Kravis claim that the average propensity to consume declines as permanent income increases.

Many economists have also objected to Friedman’s assumption of a marginal propensity to consume from transitory income equal to zero. Empirically, much evidence suggests that the marginal propensity to consume from transitory income is positive. The early empirical studies involved analysis of the impact of windfall income. These studies suggest that moderate increases in consumption are associated with the windfall income.

More recent studies suggest that the marginal propensity to consume from transitory income is larger than that suggested by the early studies. The same studies also suggest that the marginal propensity to consume from transitory income is less than the marginal propensity to consume from permanent income.

From an empirical point of view, this hypothesis is hard to test because of the difficulty of measuring permanent income and permanent consumption. Consequently, debate continues on the merits of this hypothesis (as well as other hypotheses). There is, however, a consensus that the permanent income hypothesis, broadly interpreted, is valid.

Policy Implications of the Permanent Income Hypothesis :

The implications of the permanent income hypothesis differ from those of the absolute and relative income hypotheses. Those hypotheses made no distinction between permanent and transitory income. Consequently, households are assumed to react in the same manner regardless of the type of increase in income. According to the permanent income hypothesis, households base their consumption on permanent income rather than actual income. Consequently, they will react in different ways, depending on whether they regard an increase in income as permanent or transitory.

If households receive an increase in income which they interpret as an increase in permanent income, they would increase their consumption by an amount proportional to the increase in income. On the other hand, if households interpret the increase in income as transitory, they would not increase their consumption at all.

In terms of multiplier analysis, this means that since the marginal propensity to consume from permanent income is high (Friedman estimated it to be 0.88), the multipliers (assuming the change is viewed as permanent) will be relatively large, larger in fact than suggested by the short-run consumption function. Similarly, since the marginal propensity to consume from transitory income is zero, the multipliers (assuming the change is viewed as temporary) will be small or even zero.

If either the absolute or the relative income hypothesis is valid, it makes no difference whether a change in taxes is permanent or temporary. A tax rebate or a temporary change in taxes maybe desirable in order to provide prompt and temporary stimulus or restraint to the economy. For rebates or temporary tax changes to be effective, however, a relatively large change in consumption must occur within a short time span following the rebate or change in taxes.

According to the absolute and relative income hypotheses, the changes in consumption will be large and occur within a short time span. If the permanent income hypothesis (or a similar hypothesis, such as the life cycle hypothesis) is valid, the changes in consumption will be small and occur over a relatively long time span. Consequently, the success of temporary policies largely hinges on whether households react differently to temporary changes.

In the United States, the fiscal authorities have used tax rebates and income tax surcharges on several occasions. In 1975, a tax rebate was given. The rebate was designed to increase consumption, thereby stimulating the economy. In 1968, a temporary 10 percent income tax surcharge was imposed. The tax increase was designed to reduce consumption or at least slow its rate of increase, thereby reducing inflation. Tax rebates have been proposed upon other occasions.

Franco Modigliani and Charles Steindel have examined the effects of the 1975 tax rebate upon consumption. In general, they found that the rebate results in appreciably smaller increases in consumption than those associated with a permanent tax reduction of equivalent size. They also found that the increases in consumption occurred less rapidly.

Modigliani and Steindel also considered the effects of the 1968 income tax surcharge upon consumption. They believe that the surcharge, in effect for most of the 1968-70 period, reduced consumption. The reduction, however, was appreciably less than would have occurred in the case of a permanent tax increase or equivalent size. As a result, the surcharge was relatively effective in curbing inflation.

Thus, the permanent income hypothesis and the empirical evidence suggest that rebates and temporary changes in taxes are relatively ineffective in altering consumption and hence aggregate demand. Since the empirical evidence also suggests that rebates and temporary tax changes are not completely ineffective, such actions may play a useful role in stabilizing the economy. For one thing, the US Congress is apparently much more willing to legislate temporary tax changes than permanent changes. For another, the smaller multipliers associated with rebates and temporary tax changes can be offset by making the rebates or tax changes larger.

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Permanent Income Hypothesis

• Post author: Viren Rehal
• Post published: August 16, 2022
• Post category: Consumption function / Macroeconomics
• Post comments: 0 Comments

Empirical studies and observations exposed the shortcomings of the absolute income hypothesis . It failed to explain the patterns of consumption over a long period of time. It did not consider the role of business cycles or wealth as a factor in determining consumption. As a result, several other theories emerged which attempted to explain the behaviour of consumption, such as the Permanent Income Hypothesis.

Permanent income and consumption

The permanent income hypothesis was introduced by Milton Friedman. It is based on the assumption that individuals aim for utility maximization. According to Friedman, permanent consumption is a function of the permanent income of a consumer.

Here, “ theta ” explains the proportion of permanent income used in permanent consumption, which turns out to be simply the ratio of permanent consumption to the permanent income of the consumer. The actual value of this ratio depends on several factors including the rate of interest, tastes and preferences of the given consumer and expected income.

Relationship between permanent and total income/consumption

This permanent income and permanent consumption are different from total income and total consumption in a given time period. The relationship between these can be illustrated as follows:

The transitory income and transitory consumption are random deviations from permanent income and permanent consumption respectively, which leads to differences in total income and consumption. This transitory income and consumption can be positive, negative or zero. The sum of transitory and permanent elements makes up the total income and consumption in a given time period for each individual.

assumptions made by Friedman

Friedman made some assumptions about all the above components and the way they are related to each other. These assumptions help explain the behaviour of consumption and can be stated as follows:

• There is no relationship between transitory income and permanent income. Hence, total income fluctuates randomly around the permanent income with zero covariance between the total and permanent income of different individuals.
• Similarly, there is no correlation between transitory consumption and permanent consumption. Total consumption is a random fluctuation around permanent consumption. Therefore, the covariance between total and permanent consumption is zero.
• There is no relationship between transitory income and transitory consumption. The covariance of transitory income and transitory consumption is zero. This is true because Friedman includes the purchase of non-durable goods only and not the purchase of durable goods in consumption. The usage of durable goods is included in consumption through depreciation. Therefore, if consumers purchase durable goods from transitory income, it does not have a significant effect on consumption because only usage of durables is included in consumption, not their purchase.

Empirical Evidence and explanation using Permanent Income Hypothesis

Mpc < apc in cross-sectional studies.

However, transitory consumption has no relationship with transitory income or permanent consumption. The average transitory consumption of every income group will be zero. As a result, average permanent consumption will be equal to average total consumption in every income group.

An income group ‘b’, which has an average income higher than the average population income, will have a positive average transitory income. That is, the average permanent income of that group will be less than the average total income. This difference is equal to the value of average transitory income. Since the average transitory consumption will be zero, the average permanent and average total consumption of group ‘b’ will be equal. It is shown by point “B” in the diagram.

On the other hand, income group ‘a’ has a negative average transitory income implying that the average permanent income is greater than the average total income in that case. The average total and average permanent consumption will be equal, corresponding to point A.

Similarly, the income group with an average income equal to the average population income has zero transitory income. At this point, the average permanent income is equal to the average total income of the group.

Cross-sectional consumption function

This gives rise to the cross-sectional consumption function which is shown by ‘C’. In the case of high-income group ‘b’, APC is observed at point B. Point B lies below the population consumption line, hence, APC at point B is less than the overall APC of the population which is equal to theta . Conversely, APC at point A corresponding to group ‘a’ lies higher than the population consumption line. APC is greater than the constant APC of the population (theta). Hence, APC is falling as we move from low to high-income groups and MPC<APC on the consumption function ‘C’. The slope of the cross-sectional consumption function is less than the population consumption line.

As the economy grows and average permanent income rises for all groups, this consumption function ‘C’ keeps shifting upwards along the trend, which is the population consumption line. In the long run, the observed consumption function is the population consumption line of “ theta ” with a constant APC.

Long-run and cyclical fluctuations

The explanation of consumption over a long run and short run fluctuation due to business cycles is similar to that of cross-sectional groups.

Instead of the high-income group, we have a period of boom in the economy at point B when the average transitory income is positive. The average permanent income is, therefore, less than the average total income in the economy. On the opposite end, we have a period of slump in the economy at point A. Average transitory income is negative and average permanent income is greater than the average total income in the economy.

These points A and B corresponding to periods of slump and boom, show us the short-run consumption function ‘C’. At point A, APC is greater than long-run APC ( theta ) and APC at point B is less than long-run APC. Therefore, MPC < APC in the short run corresponds to each business cycle when the slope of ‘C‘ is less than the trend line. The long-run consumption is shown by the trend line with APC = MPC at constant theta . This trend line or long-run permanent consumption is observed over a long period as the economy grows and the short-run consumption function goes on shifting upwards.

determining permanent income: adaptive expectations

This approach by Friedman divides total income into permanent income and transitory income. In reality, these two components are not observed separately, but, only the total income is observed. Therefore, Friedman used the method of adaptive expectations to separate permanent income from transitory income. Using adaptive expectation, permanent income can be extracted from total income in actual time series data as follows:

Therefore, if gamma is closer to zero, it implies that we are giving less weightage to the last period error (transitory income) and relying more on the actual income in the previous time period. On the contrary, if gamma is close to 1, we are giving high weightage to the error in determining permanent income. At gamma = 0, we completely ignore the past error. At gamma = 1, we don’t change expectations at all as we assume error will be exactly the same as last period.

The above equation shows that the permanent income in the current period depends only on past incomes. Similarly, permanent income in the previous time period (t-1) can be expressed as follows:

criticism of Permanent Income Hypothesis

• It does not explicitly account for wealth or the role of assets. It implicitly includes assets as part of consumption through the ‘usage’ of assets, measured by depreciation and rate of interest.
• In adaptive expectations, only previous period income is used to determine current permanent income. Whereas, income is a function of many factors apart from previous incomes.
• It includes the consumption of durables only through depreciation and rate of interest. The purchase of durables from transitory income or windfall gains is not considered.
• The theory assumes APC to be constant at “ theta ” while estimating permanent consumption. However, it does not have to be constant even within an income group. APC is expected to fall as income increases because lower-income groups have to spend a greater portion of their income to meet their needs.

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