Answer to Question #191785 in Macroeconomics for Julia

Question

With a help of a diagram discuss how the permanent income theory of consumption explains the difference between the cross-section and time-series estimates of the Keynesian aggregate consumption function.  

Answer 1

The Permanent Income Hypothesis, abbreviated PIH, is an economic theory that seeks to explain how agents distribute their consumption throughout their lifetimes. Milton Friedman proposed it in 1957. In its most primitive form, the theory states that an increase in permanent income, rather than shifts in temporary income, drives changes in a consumer's spending habits. Its forecasts of demand smoothing, in which people spread out temporary increases in income over time, differ from the conventional Keynesian focus on a higher marginal tendency to spend from current income. The Permanent Income Hypothesis has had a significant impact on the study of customer behavior, and it explains some of the shortcomings of Keynesian market management strategies.

Income is composed of two parts: a stable and a transient component. The central determinant of consumption in the permanent income hypothesis model is an individual's lifelong income, not his current income. The word "permanent salary" refers to the projected long-term average income.

 

Assuming customers have dwindling marginal utility, they may want to smooth out spending over time, for example, taking on debt as a student while still planning for retirement. When combined with the concept of average lifetime income, the PIH's demand smoothing element assumes that temporary increases in income will have only a minor impact on consumption. Only longer-term increases in wages would have a significant impact on consumption.