Question

Define the permanent income hypothesis. How does it relate to the more general theory of consumption under intertemporal utility maximization?

Answer 1

1. Permanent Income Hypothesis:

In its simplest form, the hypothesis states that changes in permanent income, rather than changes in temporary income, are what drive the changes in a consumer's consumption patterns.

According to Milton Friedman, the Permanent Income Hypothesis is a theory of consumer spending which states that people will spend money at a level consistent with their expected long term average income. The level of expected long term income then becomes thought of as the level of "permanent" income that can be safely spent. A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.

It supposes that a person's consumption at a point in time is determined not just by their current income but also by their expected income in future years—their "permanent income".

Income, in general consists of a permanent (anticipated and planned) component and a transitory (windfall gain/unexpected) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not his current income. Permanent income is defined as expected long-term average income.

2. How to relate it to consumption under Intertemporal utility maximisation?

Utility maximisation is a concept that,when making a purchase decision, a consumer attempts to get the greatest value possible from expenditure of least amount of money. His or her objective is to maximize the total value derived from the available money.

Intertemporal choice is an economic term describing how an individual's current decisions affect what options become available in the future. Theoretically, by not consuming today, consumption levels could increase significantly in the future, and vice versa.

The equilibrium of the economy cannot be adequately analyzed from a single point in time, but instead should be analyzed across different periods of time. According to this concept, households and firms are assumed to make decisions that affect their finances and business prospects by assessing their impact over lengthy periods of time rather than at just one point.