Permanent income hypothesis

macroeconomics

1. Permanent income hypothesis Amrina abid

2. Introduction In 1957 Milton friedman presented it in his book “The theory of consumption”. Friedman permanent theory use irving theory of consumption to rgue that consumption depend on current income. Through this theory people experience random temporary changes in their income from year to year. According to Friedman, this theory consist of two components. One is permanent income and other is transitory income.

3. Definition Permanent income : permanent income means the income that expect to persist into future. ( normal income compare with transitory income ). Denoted as: Y p Transitory income : transitory income is that part of income that people do not expect to persist in future. Denoted as: Y t Permanent income hypothesis : according t this theory people choose consumption based on permanent income and use saving and borrowing to smooth consumption in response transitory variation in income. General form of F riedman equation: C p =f( k,I,P v ,T,Y ) K= showing ratio of C&Y i = rate of interest P v = present value of human and non human value T= taste of the people Y p = permanent income

4. Assumptions Slope of budget line depends on the rate of interest. He assumed that real rate of interest remain stable overtime. Taste of consumer remains the same. The preference between present and the future income remains the same.

5. Short run consumption function (SRCF) Short run consumption function shows non proportional relationship between income and consumption MPC is less than APC. There also exist concept of measured income.

6. Long run consumption function (LRCF) According to Friedman, LRCF shows proportional relationship between income and consumption. APC remains constant and equal to MPC. LRCF lies below the 45 line which APC is less than 1.

7. Criticism APC of rich and poor is not the same because the preferences or desires for the present consumption amongst the poor are stronger than the future consumption.. It is not proper to assume that consumption is not affected by wind fall gains and losses As Thomas Mayon point out that these tests are invalid because they do not distinguish between consumption of Y t and consumption of Y o that Y produces.