Question

Using the permanent income hypothesis, explain why consumption is more stable that GDP over time.

Answer 1

The permanent income hypothesis (PIH) is an economic theory attempting to describe how agents spread consumption over their lifetimes. First developed by Milton Friedman,[1]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". 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. Its predictions of consumption smoothing, where people spread out transitory changes in income over time, departs from the traditional Keynesian emphasis on the marginal propensity to consume. It has had a profound effect on the study of consumer behavior, and provides an explanation for some of the failures of Keynesian demand management techniques.The consumption function, or Keynesian consumption function, is an economic formula that represents the functional relationship between total consumption and gross national income. It was introduced by British economist John Maynard Keynes, who argued the function could be used to track and predict total aggregate consumption expenditures.


According to the 5th Ghana Living Standard Survey Report (2008), the average annual
household expenditure in Ghana is GH¢1,918.00 whilst the mean annual per capita
consumption expenditure in Ghana is GH¢644.00. Regional differences exist with
Greater Accra Region having the highest per capita expenditure of GH¢1,050.00 whilst
Upper West has the lowest of GH¢166.00. The average annual household expenditure is
about 1.6 times higher in urban localities (GH¢2,449) than in rural localities (GH¢1,514)
even though the household size in rural households tends to be larger than urban
households (GLSS V, 2008).
Because consumption is so large and plays an important role in national welfare and
business cycle fluctuations, macroeconomists have devoted much attention, time and
energy to studying how households decide how much to consume, response to
uncertainty over future incomes, movements in interest rates, and expectations of future
shifts in taxes and wages, which are key determinants of the impact of government
policy. The concept of the consumption function, which was coined from Keynes’
fundamental psychological law, shows the relationship between consumption