Question

How do the life cycle hypothesis and the permanent-income hypothesis resolve the apparent contradiction between the short run data, which suggests a non proportional relationship between consumption and income, and the long run data, which suggests a proportional relationship? [10 marks]

Answer 1

The apparent contradicton is solved by both of these hypothesis in the following way

Life cyce hypothesis

This hypothesis says that consumers make their consumption decisions not based on their current income, but on their lifetime income. A consumer takes into account the initial years- the earning years when the income is high, and the later years- where income will go down and savings will be consumed (for example, retirement). They take all of it into account- the whole lifetime earnings, and spend in such a way that their end of life savings would be zero (or a decided amount, if they want to leave some money behind).

Permanent income hypothesis

The permanent income hypothesis says that there are two parts to all income- a permanent part and a transistory part. Permanent part is the income that a consumer expects to earn without interruption and on an average over the lifetime. Transistory income is part of income this is not permanent, such as bonuses, gains from stocks etc.

The consumption pattern that a customer has varies with these. Permanent consumption items such as food, housing etc will not be affected by transistory income and depend on permanent income. On the other hand, items such as clothes, holidays etc depend upon transistory income. That is why their consumption varies while consumption of permanent income remains mostly consistent.