Question

How do the life cycle hypothesis and the permanent income hypothesis resolve the apparent contradiction between the short-run data, which suggest a no proportional relationship between consumption and income, and the long-run data, which suggest a proportional relationship?

Answer 1

Answer:
The life cycle hypothesis and the permanent income hypothesis resolve the apparent contradiction between the short-run data, which suggest a no proportional relationship between consumption and income, and the long-run data in given below mentioned ways.

Life Cycle Hypothesis:
According to this hypothesis, it states that consumer makes the consumption decision not only based on the fact of current income but on their lifetime income. A consumer takes into account of its initial income, the earning years when income will be high and older age income as well and based on that saving will be consumed such that their end of life saving would be zero. Sometime it may not be zero but some pre decided amount that they want to leave for their childrens.

Permanent Income Hypothesis:
This hypothesis states that there are two kind of income in any one's life. The first kind of income is called permanent income which is steady income that person is imagined to be getting and averaged over its lifetime. The second kind of income is called transient income which is occasional income that he/she can get like bonus or gains from stocks.

The consumption pattern of the consumer is also depeneds on these. Permanent consumption items like daily groceries,housing and other regular services will not be affected by transient income and is mainly dependent on permanent income. On the other hand occasional consumptions like purchasing new clothes, going out for dinner, holiday planning depends on transient income. That is the reason their consumption varies keeping permanent regular consumption mostly constant.

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