Question

Milton Friedman argued, and new classical economists continue to argue (or presume) that changes in our actual or current income do not any significant effect on our actual or current consumption spending, or that our MPC is essentially zero. What was Friedman’s argument? Why did he make this argument?

Answer 1

The permanent income hypothesis (PIH) is the economic theory coined by Milton Friedman , which states that agents spread consumption over their lifetimes. 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, ie their "permanent income". In its simplest form, the hypothesis states that changes in permanent income, rather than changes in temporary income are influencing the consumption decisions of an individual. Milton believed in consumption smoothing, ie the tendency of people to spread out transitory changes in income over time, depart him from the traditional Keynesian emphasis on the marginal propensity to consume.According to Milton income has two components , permanent and transitory , positive transitory component includes bonuses,perks , tax relief etc and vice versa .
He believed that consumers experiencing diminishing marginal utility, will want to smooth out their consumption over time, e.g. take on debt as a student and also ensure savings for retirement. Coupled with the idea of average lifetime income, the consumption smoothing element regards that transitory changes in income to have only a small effect on consumption. Permanent income is determined by their assets: physical (property), financial (shares, bonds) and human (education and experience).
The PIH helps explain the failure of transitory Keynesian demand management techniques to achieve its policy targets. In Keynesian macro economic framework the marginal propensity to consume (MPC) is assumed constant, and so temporary tax cuts can have a large stimulating effect on demand. But in Milton's framework , a consumer will spread out the gains from a temporary tax cut over a long horizon, thus the stimulus effect will be much smaller.That is why he commented that MPC is essentially O .