Question

Advanced Macroeconomics:

Explain the assumptions behind the permanent income theory of consumption and explain the main predictions for consumption behaviour. Compare and contrast the implications for macroeconomic policy and economic fluctuations with those of a traditional Keynesian consumption function.

Answer 1

The permanent income theory of consumption refers to a theory that links the consumption of an individual at any point in time to that individual’s entire income earned over the lifetime. This theory based on two simple premises:

(1) that consumers would be willing to equate their expected marginal utility of consumption across time.

(2) that consumers would be able to respond to changes of income by saving and dis-saving.

The traditional Keynesian believed the consumption to be function of an interest rate such that as the rate of interest decreased the consumption expenditure increased and vice versa. They were unable to explain the constancy of the rate of the saving in the face of rising real incomes as explained in the permanent income theory. As per basic theory of Keynes, governments always hold the capability of countercyclical appropriate-tuning of macroeconomic systems through management in demand; but the permanent income hypothesis doubt this ability of governments. Moreover Keynes is concentrated mainly on short-run considerations while the permanent income theory focused primarily on long-run dynamics and relations