Permanent income hypothesis

Permanent income hypothesis

Introduction :- The permanent income hypothesis (PIH), introduced in 1957 by Milton Friedman  (1912–2006). It is a key concept in the economic analysis of consumer behavior.

Like Duesenberry’s RIH, Friedman’s hypoth­esis holds that the basic relationship between consumption and income is proportional.But according to Friedman, Consumption de­pends neither on ‘absolute’ income, nor on ‘relative’ income but on ‘permanent’ income, based on expected future income.
In other words,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.
Thus, he finds a strong relationship between Consumption and permanent income.
In permanent income hypothesis,it shows the relationship between permanent Consumption and permanent income.

ASSUMPTIONS :-

1 There is no correlation between temporary and permanent income.

2 There is no correlation between permanent and temporary consumption.

3 There is no correlation between temporary consumption and temporary income.

4 Only changes in fixed income allow consumers to Provide adjustments.

Explanation of Permanent Income Hypothesis :-

Friedman divides the current measured income into two components : permanent income (Yp) and transitory income (Yt).

Thus, Y = Yp + Yt.

Permanent in­come (Yp) may be defined as ‘the mean income’, that is determined by the expected or measured income to be received over a long period of time.
And transitory income includes unexpected or sudden income which is may be unanticipated.

Similarly,Milton Friedman divided the Consumption into two components .i.e, permanent consumption (Cp) and transistory consumption (Ct).

Thus, C = Cp + Ct.

Permanent consumption (Cp) may be regarded as compulsory Consumption which is independent from the level of income (e.g-food ,house, rent, etc.).

Transistory consumption (Ct) may be defines as unanticipated or sudden spendings which could not be expected in future (e.g- accidents, marriage, illness etc.)

The basic or important argument is that perma­nent consumption depends on permanent in­come. The relationship of PIH is that permanent consumption is proportional to permanent income that exhibits a fairly con­stant APC.

That is, Cp = kYp........ (1)

Where k is con­stant and equal to APC and MPC.
As we look at the Assumption,Friedman assumes that there is no correlation between Yp and Yt, between Yt and Ct and between Cp and Ct. That is

RYt. Yp = RYt . Ct = RCt. Cp = 0.

But strong correlation between Yp and Cp exist.
Since Yt is uncorrected with Yp. Then the average transitory income would be equal to zero of all income groups.This is similar for the transitory components of consump­tion.Thus, for all the families taken together the average transitory income and average transitory consumption are zero.Thus,
Yt = Ct = 0.
Now it follows that

Y = Yp and C = Cp

Since the individual's measured income or current income is Y, it can be more or less than his permanent income in any period.This happens because these families had enjoyed unexpected in­comes thereby making transitory incomes positive and Yp<Y. Similarly, for a sample of families with below-average measured in­ come, transitory incomes become negative and Yp>Y.

Now take permanent income which is based on time series. Friedman believes that permanent income depends partly on current income and partly on previous period’s income. This can be measured as

Ypt = aYt + (1-a) Yt-1........(2)

where Ypt = permanent income in the current period, Yt = current income in the current period, Yt-1 = previous period’s income, a – ratio of change in income between current period (t) and previous period (t-1).

This equation tells that permanent income is the sum of current period’s income (Yt) and previous periods income (Yt-1) and the ratio of income change between the two (a). If the current income increases at once, there will be small increase in permanent income.

By integrating equations (1) and (2), short-run and long-run consumption function can be explained as

C t = kYpt = kaYt + k (1-a) Yt-1 …(3)

Where Ct  = current period consumption, ka = short-run MPC, k = long-run MPC and k (1-a) Yt-1, is the intercept of short-run consumption function.

Acc. To Friedman, k and ka are different from one another and k > ka. Further, k = 1 and ka = 0

Equation (3) tells that consumption depends both on previous income and current income. Previous income is important for consumption because it helps in forecasting the future income of people.

Explanation through diagram :-

Given above, assumptions give the explanation of the cross-section results of Friedman’s theory that the short-run consumption function is linear and non-proportional, i.e., APC > MPC and the long-run consumption function is linear and proportional, i.e., APC = MPC.

Above figure explaines that
permanent income hypothesis of Friedman where CL is the long-run consumption function which represents the long-run proportional relationship between consumption and income of an individual where APC = MPC. Cs is the non- proportional short-run consumption function where measured income includes both permanent and transitory components.

At OY income level where Cs and CL curves coincide at point E, permanent income and measured income are identical and so are permanent and measured consumption as shown by YE. At point E, the transitory factors are non-existent. If the consumer’s income increases to OY1 he will increase his consumption consistent with the rise in his income.

For this, he will move along the Cs curve to E2 where his measured income in the short-run is OY1 and measured consumption is Y1E2. The reason for this movement from E to E2 is that during the short-run the consumer does not expect the rise in income to be permanent, so APC falls as income increases.

But if the OY1 income level becomes permanent, the consumer will also increase his consumption permanently. Now his short-run consumption function will shift upward from Cs to CS1 and intersect the long-run consumption function CL at point E1.

Thus the consumer will consume Y1E1 at OY1 income level. Since he knows that the increase in his income OY1 is permanent, he will adjust his consumption Y1E1 accordingly on the long-run consumption function CL at E1 where APC = MPC

Related article:- relative-income-hypothesis.