Permanent and Life Cycle Income Hypothesis

Permanent and Life Cycle Income Hypothesis consumption theory

1. Permanent Income Hypothesis (PIH) Objectives By the end of this lesson the student should be able to: Explain Permanent income hypothesis Distinguish between the two component of income Explain how PIH solves the consumption puzzle Explain the Life - Cycle Hypothesis (LCH) Derive the basic model of the LCH 1

2. Permanent Income Hypothesis Cont.…. The Permanent Income Hypothesis was developed by Milton Friedman in 1957. He argued that a person’s consumption spending is related to his or her permanent income. According to Friedman, current income (Y) should be viewed as the sum of two components of income Permanent income , and Transitory Income i.e. Consumers use saving & borrowing to smooth consumption in response to transitory changes in income Permanent Income : The regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned. Transitory Income : The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year.   2

3. Permanent Income Hypothesis Cont.…. Where k is coefficient proportionality, which Friedman assumed, depend on factors like household preferences, rate of interest, demographic factors, human wealth etc. For example, if a person received a permanent raise of GHS2m, his consumption would rise by about as much. Yet if a person won GHS2 in a jackpot, he would not consume it all in one year. He is likely to spend the extra consumption over the rest of his life. Thus, This is Friedman’s consumption Function   3

4. Permanent Income Hypothesis Cont.…. The PIH solves the consumption puzzle by suggesting that the standard Keynesian consumption function used the wrong variables. Consumption depends on permanent income yet many of the studies used current income Thus, Friedman argues that this error in variables problem explains the seemingly contradictory findings Given Where Y = Current income and K is the fraction of permanent income that people consume per year The PIH implies   4

5. Permanent Income Hypothesis Cont.…. According to Friedman, if all variation in current income came from the permanent component, one would not observe differences in APC But since some of the variation in income comes from the transitory component, it implies that households with high transitory income would have a lower consumption For example, if high-income households have higher transitory income than low-income households, APC will be lower in high-income households. Similarly, Friedman argued that year to year fluctuations in income are dominated by transitory income Therefore, years of high income should be years of low APC’s but over the long run, income variation is due mainly (if not solely) to variation in permanent income, which implies a stable APC. 5

6. Permanent Income Hypothesis Cont.…. Summary of PIH The PIH suggest that consumption decision are based on average long-run or permanent income. Changes in income, which are viewed as temporary may not affect consumption Pattern 6

7. Life Cycle Hypothesis (LCH) This was developed by Franco Modigliani, Nobel Prize in 1985. The LCH says that income varies systematically over the phases of the consumer’s “life cycle,” and saving allows the consumer to achieve smooth consumption. Life-cycle hypothesis- Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement. Hence because individuals want to maintain a smooth consumption level throughout their life time, their consumption becomes dependent on their Wealth and income as well as their life span and age for retirement 7

8. Life Cycle Hypothesis Cont.… THE BASIC MODEL OF LCH Consider a consumer who expect to live another T years, has wealth of W and expected to earn income Y until she retired at R years from now. We want to find out the level of consumption the consumer will choose if she wish to maintain a smooth level of consumption over her life Assumptions Zero real interest rate (for simplicity) Consumption-smoothing is optional 8

9. Life Cycle Hypothesis Cont.…. Where W = initial wealth Y = annual income until retirement (assumed constant) R = number of years until retirement T = lifetime in years   9

10. Life Cycle Hypothesis Cont.…. To achieve smooth consumption, the consumer divides his/her resources equally over time (1) (2) Where is the marginal propensity to consume out of wealth and is the marginal propensity to consume out of income It can clearly be seen from the above that aggregate consumption depends on both wealth (W) and income (Y) (3)   10

11. Life Cycle Hypothesis Cont.…. From equation 3, the life-cycle consumption function implies (4) Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households. Over time, aggregate wealth and income grow together, causing APC to remain stable.   11

12. End of Presentation on PIH and LCH Thank you 12