Friedman’s permanent income hypothesis rejects the use of “current income” as the determinant of consumption expenditure and instead divides both consumption and income into “permanent” and “transitory” components, so that
Ym or Y = YP + Yt …(1)
and C = CP + Ct …(2)
where p refers to permanent, t refers to transitory, Y to income and C to consumption.
Permanent income is defined as “the amount a consumer unit could consume (or believes that it could) while maintaining its wealth intact.” It is the main income of a family unit which in turn depends on its time- horizon and farsightedness. “It includes non-human wealth that it owns, the personal attributes of earners in the unit…the attributes of the economic activity of the earners such as the occupation followed, the location of economic activity, and so on.”Y being the consumer’s measured income or current income, it can be larger or smaller than his permanent income in any period. Such differences between measured and permanent income are due to the transitory component of income (Yt ). Transitory income may rise or fall with windfall gains or losses and cyclical variations. If the transitory income is positive due to a windfall gain, the measured income will rise above the permanent income. If the transitory income is negative due to theft, the measured income falls below the permanent income. The transitory income can also be zero in which case measured income equals permanent income.
Permanent consumption is defined as “the value of the services that it is planned to consume during the period in question.” Measured consumption is also divided into permanent consumption (Cp ) and transitory consumption (Ct). Measured consumption (or current consumption) may deviate from or equal permanent consumption depending on whether the transitory consumption is positive, negative or zero, Permanent consumption (Cp ) is a multiple (k) of permanent income, Yp .
CP = kYP
and k = f (r, w, u)
Therefore, CP = k (r, w, u) YP …(3)
where k is a function of the rate of interest (r), the ratio of property and non-property income to total wealth or national wealth (w), and the consumer’s propensity to consume (u). This equation tells that over the long period consumption increases in proportion to the change in YP. This is attributable to a constant k (=Cp /Yp ) which is independent of the size of income. Thus k is the permanent and average propensity to consume and APC = MPC.
Friedman analyses the offsetting forces which lead to this result. To take the rate of interest (r), there has been a secular decline in it since the 1920s. This tends to raise the value of k. But there has been a long-run decline in the ratio of property and non-property income to national wealth (w) which tends to reduce the value of k. The propensity to consume has been influenced by three factors.
First, there has been a sharp decline in the farm population which has tended to increase consumption with urbanisation. This has led to increase of k.
Second, there has been a sharp decline in the size of families. It has led to increase in saving and reduction in consumption thereby reducing the value of k.
Third, larger provision by the state for social security. This has reduced the need for keeping more in savings. It has increased the tendency to consume more resulting in the rise in the value of k.
The overall effect of these off-setting forces is to raise consumption in proportion to the change in the permanent income component. Therefore, there is a proportional relation between permanent income and consumption,
Cp = kYp …(4)
where k is the coefficient of proportionality in which APC and MPC are endogenous and it depends upon the above mentioned factors. In other words, it is that proportion of fixed income which is consumed. Now take permanent income which is based on time series. Friedman believes that permanent income depends partly on current income and partly on previous period’s income. This can be measured as
Ypt = aYt + (1–a) Yt–1 …(5)
where Ypt = permanent income in the current period, Yt = current income in the current period, Yt-1 = previous period’s income, a = ratio of change in income between current period (t) and previous period (t–1).
This equation tells that permanent income is the sum of current period’s income (Yt ) and previous periods income (Yt–1 ) and the ratio of income change between the two (a). If the current income increases at once, there will be small increase in permanent income. For the permanent income toincrease, income will have to be raised continuously for many years. Then only people will think that it has increased.
By integrating equations (4) and (5), short-run and long-run consumption function can be explained as
Ct = kYpt = kaYt + k (1–a)Yt-1 …(6)
where Ct = current period consumption, ka = short-run MPC, k = long-run MPC and k (1–a) Yt-1 is the intercept of short-run consumption function.
According to Friedman, k and ka are different from one another and k >ka. Further, k = 1 and ka = 0
Equation (6) tells that consumption depends both on previous income and current income. Previous income is important for consumption because it helps in forecasting the future income of people.
Given these, Friedman gives a series of assumptions concerning the relationships between permanent and transitory components of income and consumption.
1. There is no correlation between transitory income and permanent income.
2. There is no correlation between permanent and transitory consumption.
3. There is no correlation between transitory consumption and transitory income.
4. Only differences in permanent income affect consumption systematically.
Explanation of the Theory
These assumptions give the explanation of the cross-section results of Friedman’s theory that the short-run consumption function is linear and non-proportional, ie. APC >MPC and the long-run consumption function is linear and proportional, ie. APC = MPC.
Figure 6 explains the permanent income hypothesis of Friedman where CL is the long-run consumption function which represents the long-run proportional relationship between consumption and income of an individual where APC = MPC. CS is the non- proportional short-run consumption function where measured income includes both permanent and transitory components. At OY income level where CS and CL curves coincide at point E, permanent income and measured income are identical and so are permanent and measured consumption as shown by YE. At point E, the transitory factors are non-existent. If the consumer’s income increases to OY1, he will increase his consumption consistent with the rise in his income. For this, he will move along the CS curve to E2 where his measured income in the short-run is OY1 and measured consumption is Y1E2. The reason for this movement from E to E2 is that during the short-run the consumer does not expect the rise in income to be permanent, so APC falls as income increases. But if the OY1 income level becomes permanent, the consumer will also increase his consumption permanently. Now his short-run consumption function will shift upward from CS to CS1 and intersect the long-run consumption function CL at point E1. Thus the consumer will consume Y1E1 at OY1 income level.
Since he knows that the increase in his income OY1 is permanent, he will adjust his consumption Y1E1 accordingly on the long-run consumption function CL at E1 where APC = MPC
This theory has been criticised on the following counts:
1. Correlation between Temporary Income and Consumption
Friedman’s assumption that there is no correlation between transitory components of consumption and income is unrealistic. This assumption implies that with the increase or decrease in the measured income of the household, there is neither any increase or decrease in his consumption, because he either saves or dissaves accordingly. But this is contrary to actual consumer behaviour. A person who has a windfall gain does not deposit the entire amount in his bank account but enjoys the whole or part of it on his current consumption. Similarly, a person who has lost his purse would definitely cut or postpone his present consumption rather than rush to the bank to withdraw the same amount of money to meet his requirements.
2. APC of all Income Groups not Equal
Friedman’s hypothesis states that the APC of all families, whether rich or poor, is the same in the long- run. But this is against the ordinary observed behaviour of households. It is an established fact that low-income families do not have the capacities to save the same fraction of their incomes as the high income families. This is not only due to their meagre incomes but their tendency to prefer present consumption to future consumption in order to meet their unfulfilled wants. Therefore, the consumption of low-income families is higher relative to their incomes while the saving of high-income families is higher relative to their incomes. Even in the case of persons at the same level of permanent income, the level of saving differs and so does consumption.
3. Use of Various terms Confusing
Friedman’s use of the terms “permanent”, “transitory”, and “measured” have tended to confuse the theory. The concept of measured income improperly mixes together permanent and transitory income on the one hand, and permanent and transitory consumption on the other.
4. No Distinction between Human and Non-human Wealth
Another weakness of the permanent income hypothesis is that Friedman does not make any distinction between human and non-human wealth and includes income from both in a single term in the empirical analysis of his theory.
Despite these weaknesses, “it can be fairly said”, according to Micheal Evans, “that the evidence supports this theory and that Friedman’s formulation has reshaped and redirected much of the research on the consumption function.”