Question

Explain how the permanent income hypothesis solves the consumption puzzle.

Answer 1

Permanent income hypothesis states that consumers send their income at a consistent level keeping their future income in mind.

The consumption of the people in the permanent income hypothesis does not depend on the impulsive spending of the consumers. The consumption pattern remains nearly uniform throughout the life. If a person gets bonus in a particular year, he will not be spending the amount immediately. But, he will try to save his bonus and try to increase his income till it rises to a particular level. After that only the individual will spend at a higher level. He will try to increase his income first and then spend because then only he can spend his increased income throughout his life and not at a particular point in life.

Milton Friedman talked about this theory. He stated even with the increased income of the people, they might not buy a greater number of things or luxury goods. This is because of tastes and preferences of different consumers. In this case with the policy of the government of an increased income will not work.

Thus the theory of permanent income solves the consumption puzzle as this theory does not believe in impulsive buying of the goods.