Question

INSTRUCTIONS: DEFINE THE FOLLOWING TERMS AND CONCEPTS IN A CLEAR, CONCISE, AND EXPLICIT WAY. DEMONSTRATE THE RELATIONS BETWEEN THEM!

Permanent and life cycle income theories of consumption & Keynesian consumption function;

Answer 1

Permanent income hypothesis:

A 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.

Permanent Income Hypothesis

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What is a 'Permanent Income Hypothesis'

A 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.

The permanent income hypothesis was formulated by the Nobel Prize winning economist Milton Friedman in 1957. The hypothesis implies that changes in consumption behavior are not predictable, because they are based on individual expectations. This has broad implications concerning economic policy. Under this theory, even if economic policies are successful in increasing income in the economy, the policies may not kick off a multiplier effect from increased consumer spending. Rather, the theory predicts there will not be an uptick in consumer spending until workers reform expectations about their future incomes.

For example, if a worker is aware they are likely to receive an income bonus at the end of a particular pay period, it is plausible that their spending in advance of that bonus may change in anticipation of the additional earnings. However it is also possible that workers may choose to not increase their spending based solely on a short-term windfall. They may rather make efforts to increase their savings, based on the expected boost in income. Similar can be said of individuals who are informed they are to receive an inheritance; their personal expenditures could change to take advantage of the anticipated influx of funds but per this theory they may maintain their current spending levels in order to save the supplemental assets. Likewise they may seek to invest those supplemental funds in order to provide long-term growth of their money rather than spend it immediately on disposable products and services.

The liquidity of the individual can play a role in their future income expectations. An individual with no assets may already be in the habit of spending without regard to their income, current or future.

Changes over time, however, through incremental salary raises or the assumption of new long-term jobs that bring higher, sustained pay can lead to changes in permanent income. With their expectations elevated, employees may allow their expenditures to scale up in turn.

Life cycle hypothesis:

Life-Cycle Hypothesis (LCH)

The Life-Cycle Hypothesis (LCH) is an economic theory that pertains to the spending and saving habits of people over the course of a lifetime. The concept was developed by Franco Modigliani and his student Richard Brumberg. LCH presumes that individuals plan their spending over their lifetimes, taking into account their future income. Accordingly, they take on debt when they are young, assuming future income will enable them to pay the debt off. They then save during middle age in order to maintain their level of consumption when they retire. This results in a "hump-shaped" pattern in which wealth accumulation is low during youth and old age, and high during middle age.

The Life Cycle Hypothesis replaced an earlier hypothesis developed by economist John Maynard Keynes. He believed that savings were just another good and that the percentage that individuals allocated to savings would grow as their incomes rose. This presented a potential problem in that it implied that as a nation's incomes grew, a savings glut would result, and aggregate demand and economic output would stagnate. Subsequent research has generally supported the Life Cycle Hypothesis.

The consumption function, or Keynesian consumption function, is an economic formula representing 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.

The consumption function is represented as:
C=A+MD
Where:

C = Consumer spending

A = Autonomous consumption

M = Marginal propensity to consume

D = Real disposable income

The classic consumption function suggests consumer spending is wholly determined by income and the changes in income. If true, aggregate savings should increase proportionally as gross domestic product (GDP) grows over time. The idea is to create a mathematical relationship between disposable income and consumer spending, only on aggregate levels.

The stability of the consumption function, based in part on Keynes' Psychological Law of Consumption, especially when contrasted with the volatility of investment, is a cornerstone of Keynesian macroeconomic theory. Most post-Keynesians admit the consumption function is not stable in the long run; consumption patterns change as income rises.

Assumptions and Implications

Much of the Keynesian doctrine centers around the frequency with which a given population spends or saves new income. The multiplier, the consumption function and the marginal propensity to consume are each crucial to Keynes’ focus on spending and aggregate demand.

The consumption function is assumed stable and static; all expenditures are passively determined by the level of national income. The same is not true of savings, which Keynes called “investment,” not to be confused with government spending, another concept Keynes often defined as investment.

For the model to be valid, the consumption function and independent investment must remain constant long enough for national income to reach equilibrium. At equilibrium, business expectations and consumer expectations match up. One potential problem is the consumption function cannot handle changes in the distribution of income and wealth. When these change, so too might autonomous consumption and the marginal propensity to consume.