Explain how the permanent income hypothesis reconciles the difference between short-run and long-run consumption behavior.

 Nobel Prize winner economist Friedman Milton suggested a theory of permanent income hypothesis or theory of consumption. His theory explains consumer behaviour. Friedman classified the current income Y into two parts Permanent Income Yp and Transitory Income Yt . Thus,

Y = Yp +Yt

Permanent income is that part of income which is certain, i.e. there is no doubt about occurring of this income in future while transitory income is subject to contingency or its occurrence is doubtful. Friedman says that permanent income is expected but temporary income is not expected by consumers.

For example, if a person is a Chartered Accountant, Advocate, Doctor, Engineer, etc., he or she will earn higher permanent income but think about a farmer whose income depends upon the harvest production, which in turn depends upon weather conditions.

If weather conditions go good, then the farmer will get income and in case of opposite weather conditions, he may lose too. Hence, his income is regarded as transitory income. Friedman argues that consumption depends mainly on permanent income because consumers use saving and borrowing to smooth consumption in response to transitory income.

Mankiw says in this regard, i.e. if a person received a permanent raise of $10000 per year, his consumption would rise by about as much. Yet if a person won $10000 in a lottery, he would not consume it all in one year. Instead, he would spread the extra consumption over the rest of his life. Assuming an interest rate of zero and a remaining life span of 50 years, consumption would rise by only $200 per year in response to the $10000 prize.

Thus, consumers spend their permanent income, but they save rather than spend most of their transitory income. Hence, on the basis of above discussion it can be concluded that Friedman’s consumption mainly depends upon permanent income and this is denoted as follows:

C=aYp

Where, a measures the part of permanent income consumed. 

The implication of permanent income hypothesis is that since Keynesian consumption depends upon disposable income while Friedman’s consumption depends upon permanent income, hence, Keynesian consumption function includes a wrong variable. However, empirical studies show that consumption depends upon current income. Friedman argued that this error in variables problem explains the seemingly contradictory findings.

Average propensity to consume of Friedman consumption function is defined as follows:

APC=C=aYP=aYP 

It is clear from the above equation that APC depends upon the ratio of permanent income and current income. When current income increases temporarily above permanent income, then APC falls temporarily or vice versa.

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