Question

The creation of the Permanent Income Hypothesis was generated out of the observed difference between short-run and long-run consumption behavior. Explain this difference.

Answer 1

Permanent Income Hypothesis is developed by Milton Friedman. 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. That means permanent income hypothesis says one consumers current consumption depend on not only the current income but their expected future income or permanent income also. Which holds the basic relationship between aggregate consumption and aggregate income is proportional but the relatiomnship here is expressed in terms of permanent income and permanent consumption.

According to cross sectional and time series analysis permanent income hypothesis provide a linear and proportional consumption function Because Long run data shows the proportional relationship However the studies relating to shortrun between income and consumption shows non proportional relationship. The non proportional relationship between consumption and income in short run based on positive and negative transitory income( differents between measured income and permanent income)components that appear respectively in the aggregate measured income and below average years.

More over the short run consumption function has a positive intercept and a relatively low marginal propensity to consume while the long run consumption function is essentially proportional to income significantly constant and much larger marginal propensity to consume.This differents lead to life cycle hypothesis and permanent income hypothesis, to the view that “short-run income” was a poor proxy for life-cycle or permanent income. If income is temporarily high, the consumer will know this and want to save more for the leaner times to come, inpermanent income approach. According to life cycle approach if income is high at one portion of the life cycle that is  peak in the working years income will be saved for retirement and to pay off earlier educational and other debt that was optimal to undertake at that time. These are shows the the creation of the Permanent Income Hypothesis was generated out of the observed difference between short-run and long-run consumption behavior.