Question

According to the Permanent Income Hypothesis, a person’s consumption decreases only when

A. The person's average lifetime income decreases.

B. The person saves less.

C. The person's income decreases unexpectedly.

D. The person's current income decreases.

Answer 1

Permanent Income Hypothesis

Milton Friedman formulated the theory of Permanent Income Hypothesis which refers to the consumption or spending of people consistent to an expected level of their long term average income. According to the theory, a person reduces his or her level of consumption only accordance to a reduction in average life time income which is expected.  

The consumption or spending do not affects much to a temporary or sudden change in the level of income, but is affected to a change in the long-term expected average income. An individual by saving less will only consume more in the short run. A less savings cannot reduce the level of consumption. Also, according to the Permanent Income Hypothesis, an individual will saves only when his expected long-term average income is less than that of the current income. That even shows a less savings cannot reduce the level of consumption.

An unexpected rise or fall in income will affect the level of consumption much. So, a sudden fall or decrease in income will not reduce the level of consumption much. As the theory suggests, consumption is only affected by the expected long term average income.

A reduction in the current income will not do much with the level of consumption. As the theory says, a fall in current income will not affect the consumption much since that has nothing to do with a temporary shift in income but only on a permanent long term expected average income.