Question

Explain the ‘permanent income’ theory of household consumption expenditure.

Answer 1

Permanent income hypothesis is income was introduded by Milton Friedman. According Permanent Income Hypothesis, permanent income is the income for steady rate of consumption. Consumption of an individual is determined by long run expected income rather than current level of income. He argues that an individual would prefer a smooth consumption flow per day rather than plenty of consumption today and little consumption tomorrow. Permanent income is earned from both human and non -human wealth

Cp = kYp

Cp= permanent consumption

k= proportion of permanent income that is consumed.

Yp = permanent income

Permanent income is the last years income +a fraction of difference between this year income and last year income

Yc =Yp+Yt

Yc= current income

Yp= permanent income

Yt = transitory income

Transitory income is unexpected or windfall gain income. Transitory income is independent of consumption

When income increases, consumption increases at high speed. When income falls, consumption falls at low speed. Marginal propensity of consumption of measured income is less than the marginal propensity of consumption of permanent income

Permanent income hypothesis is also consistent with the evidence from the cross sectional budget studies that high income familiea have average propensity to consume than that of low income familiea