Question

Describe Milton Friedman’s Permanent Income Hypothesis and one major alternative hypothesis of consumer behavior. Briefly describe the evidence for or against Friedman’s hypothesis. How does his hypothesis stand up after all these years?

Answer 1

The permanent income hypothesis is a consumer spending theory which states that people will spend money at a level which is consistent with their expected long-term average income. This expected long-term income then becomes the level of “permanent” income which can be safely spent.

This hypothesis was given by the Nobel Prize–winning economist Milton Friedman in the year 1957 and it implies that changes in consumption behavior cannot be predicted since they are based on individual expectations. As per this theory, economic policies may be successful in increasing income in the economy, but the policies do not cause a multiplier effect from the increased consumer spending. Rather, this theory predicts that there will not be an increase in consumer spending until workers change their expectations about their future incomes.

Working of Permanent Income Hypothesis

For example, if a worker knows that he is likely to receive an income bonus at the end of a particular period, it is possible that the worker’s spending in advance of that bonus may change as he is expecting additional income. But, it is also possible that workers may choose not to increase their spending based only on a short-term windfall. Instead they may make efforts to increase their savings, based on the expected hike in income.

The liquidity of the individual can also play a major role in his expectations about future income. Individuals who have no assets have the habit of spending without regard to their income, current or future.

One major alternative hypothesis of consumer behavior- Life Cycle Hypothesis

The Life-Cycle Hypothesis (LCH) is an economic theory that is related to the spending and saving habits of people over the course of a lifetime. It was given by Franco Modigliani and his student Richard Brumberg and presumes that individuals plan their spending over their lifetimes and take their future incomes into account . So, they take on debt when they are young, expecting that the future income will enable them to pay the debt off and save during middle age to maintain their level of consumption when they retire. The Life Cycle Hypothesis replaced an earlier hypothesis which was given by John Maynard Keynes. According to him, savings were just another good and the amount allocated by individuals to savings would grow as their incomes rose. This led to a potential problem as it implied that as a nation's incomes will grow, it would result in a savings glut, and aggregate demand and economic output would fall. Though a subsequent research has usually supported the Life Cycle Hypothesis.

Since permanent income is a concept of long-run, it does not differ to the same degree as actual income over the business cycle. As a result, when the business cycle is at its peak, actual income is more than permanent income. Since actual income is more than permanent income, so the transitory income is positive.

Criticism of the Permanent Income hypothesis has centered on two main assumptions:

(1) The assumption of a constant average propensity to consume;

(2) The assumption of a marginal propensity to consume from transitory income equal to zero.

Also Irwin Friend and Irving B. Kravis have opposed the Friedman’s assumption of a constant average propensity to consume. They are satisfied that households with low levels of permanent income are under much heavier pressure to consume than the households with much higher levels of permanent income.

Many economists have also opposed to Friedman’s assumption of a marginal propensity to consume from transitory income equal to zero. More recent studies suggest that the MPC from transitory income is more than that suggested by the early studies. The same studies also shows that the MPC from transitory income is less than that from permanent income.

Overall, this hypothesis is hard to test due to the difficulty of measuring permanent income and permanent consumption. As a result, the debate continues on the merits of this hypothesis .There is, however, a consensus that the permanent income hypothesis is maybe valid.