Answer to Question #277328 in Macroeconomics for Sandeep

Question

Descibe how the permanent income hypothesis makes current consumption a function of wealth and current labour income

Answer 1

Permanent income hypothesis is a theory about consumer spending that states people spend money consistent with their expected long term average income. The expected long term income is now taken as permanent income that an individual can safely spend. An individual only saves if their current income is higher than the anticipated level of permanent income for them to guard future declines in income.

The theory was advance by Milton Friedman in 1957. He argued that people prefer to smooth their consumption rather than let it bounce around due to short term fluctuations in income.   Changes over time through incremental salaries or assumption that new long term jobs bring higher sustained pay translating to permanent income and therefore the individual elevates their expenditure based on the permanent income. This concludes that consumption is function of wealth and current income.