macroeconomics

1. PERMANENT INCOME
HYPOTHESIS
Amrina abid

2. Introduction
■ In 1957 Milton friedman presented it in his book “The theory of consumption”.
■ Friedman permanent theory use irving theory of consumption to rgue that
consumption depend on current income.
■ Through this theory people experience random temporary changes in their income
from year to year.
■ According to Friedman, this theory consist of two components.One is permanent
income and other is transitory income.

3. Definition
■ Permanent income: permanent income means the income that expect to persist into future. ( normal
income compare with transitory income ). Denoted as: Yp
■ Transitory income: transitory income is that part of income that people do not expect to persist in
future. Denoted as: Yt
■ Permanent income hypothesis: according t this theory people choose consumption based on
permanent income and use saving and borrowing to smooth consumption in response transitory
variation in income.
General form of Friedman equation: Cp=f(k,I,Pv,T,Y)
K= showing ratio of C&Y
i= rate of interest
Pv= present value of human and non human value
T= taste of the people
Yp= permanent income

4. Assumptions
■ Slope of budget line depends on the rate of interest.
■ He assumed that real rate of interest remain stable overtime.
■ Taste of consumer remains the same.
■ The preference between present and the future income remains the same.

5. Short run consumption function
(SRCF)
■ Short run consumption function shows non proportional relationship between income
and consumption
■ MPC is less thanAPC.
■ There also exist concept of measured income.
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6. Long run consumption function
(LRCF)
■ According to Friedman, LRCF shows proportional relationship between income and
consumption.
■ APC remains constant and equal to MPC.
■ LRCF lies below the 45 line whichAPC is less than 1.
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7. Criticism
■ APC of rich and poor is not the same because the preferences or desires for the
present consumption amongst the poor are stronger than the future consumption..
■ It is not proper to assume that consumption is not affected by wind fall gains and
losses
■ AsThomas Mayon point out that these tests are invalid because they do not
distinguish between consumption ofYt and consumption ofYo thatY produces.