3. Permanent-Income Hypothesis
• Friedman suggested that we view current income Y as the sum of two components,
permanent income YP
and transitory income YT
. That is,
Y = YP
+ YT
• Permanent income is the part of income that people expect to persist into the future.
Transitory income is the part of income that people do not expect to persist. Put
differently, permanent income is average income, and transitory income is the
random deviation from that average.
4. Permanent-Income Hypothesis
To see how we might separate income into these two parts, consider these examples:
Maria, who has a law degree, earned more this year than John, who is a high-school
dropout. Maria’s higher income resulted from higher permanent income, because her
education will continue to provide her a highe salary.
Sue, a Florida orange grower, earned less than usual this year because a freeze
destroyed her crop. Bill, a California orange grower, earned more than usual because
the freeze in Florida drove up the price of oranges.
Bill’s higher income resulted from higher transitory income, because he is no more
likely than Sue to have good weather next year.
5. Permanent-Income Hypothesis
• Friedman reasoned that consumption should depend primarily on permanent
income, because consumers use saving and borrowing to smooth consumption in
response to transitory changes in income.
• Thus, consumers spend their permanent income, but they save rather than spend
most of their transitory income. Friedman concluded that we should view the
consumption function as approximately
C = aYP
• Where a is a constant that measures the fraction of permanent income consumed.
The permanent-income hypothesis, as expressed by this equation, states that
consumption is proportional to permanent income.
6. Permanent-Income Hypothesis
• The permanent-income hypothesis solves the consumption puzzle by suggesting
that the standard Keynesian consumption function uses the wrong variable.
• According to the permanent-income hypothesis, consumption depends on
permanent income; yet many studies of the consumption function try to relate
consumption to current income.
• Friedman argued that this errors-in-variables problem explains the seemingly
contradictory findings.
• According to the permanent-income hypothesis, the average propensity to consume
depends on the ratio of permanent income to current income.
• When current income temporarily rises above permanent income, the average
propensity to consume temporarily falls.
• When current income temporarily falls below permanent income, the average
propensity to consume temporarily rises.
7. Permanent-Income Hypothesis
• Now consider the studies of household data. Friedman reasoned that these data
reflect a combination of permanent and transitory income. Households with high
permanent income have proportionately higher consumption.
• If all variation in current income came from the permanent component, the average
propensity to consume would be the same in all households. But some of the
variation in income comes from the transitory component, and households with high
transitory income do not have higher consumption.
• Therefore, researchers find that high-income households have, on average, lower
average propensities to consume.
9. Random Walk Hypothesis
• The economist Robert Hall was the first to derive the implications of rational
expectations for consumption.
• He showed that if the permanent-income hypothesis is correct, and if consumers
have rational expectations, then changes in consumption over time should be
unpredictable.
• When changes in a variable are unpredictable, the variable is said to follow a
random walk.
• According to Hall, the combination of the permanent-income hypothesis and
rational expectations implies that consumption follows a random walk.
• Hall reasoned as follows. According to the permanent-income hypothesis,
consumers face fluctuating income and try their best to smooth their consumption
over time.
10. Random Walk Hypothesis
• At any moment, consumers choose consumption based on their current expectations
of their lifetime incomes.
• Over time, they change their consumption because they receive news that causes
them to revise their expectations.
• For example, a person getting an unexpected promotion increases consumption,
whereas a person getting an unexpected demotion decreases consumption.
• In other words, changes in consumption reflect “surprises” about lifetime income. If
consumers are optimally using all available information, then they should be
surprised only by events that were entirely unpredictable.
• Therefore, changes in their consumption should be unpredictable as well.
11. Random Walk Hypothesis
• If consumers obey the permanent-income hypothesis and have rational expectations,
then only unexpected policy changes influence consumption.
• These policy changes take effect when they change expectations.
• Hence, if consumers have rational expectations, policymakers influence the economy
not only through their actions but also through the public’s expectation of their
actions.
• Expectations, however, cannot be observed directly.
• Therefore, it is often hard to know how and when changes in fiscal policy alter
aggregate demand.
