Consumption Pattern of Tamilnadu with Reference to Permanent Income Hypothesis

Topics: Macroeconomics, Economics, Permanent income hypothesis Pages: 17 (4670 words) Published: June 19, 2013

_______________________________________________________________________________ Introduction
The central idea of the permanent income hypothesis, proposed by Milton Friedman in 1957, is that people base consumption on what they consider their “normal income”. In doing this, they attempts to maintain a fairly constants standard of living even thought their incomes may vary considerably from month to month or from year to year. As a result, increase and decrease in income that people see as temporary have little effect on their consumption spending. Friedman asserts that consumption is determined by long term expected income rather than current level of income. It is this long-term expected income which is called by Friedman as permanent income on the basis of which people make their consumption plans. To make this point clear, Friedman gives an example which is worth quoting.

“An individual who is paid or receives income only once a week, say on Friday, he would not concentrate his consumption on one day with zero consumption on all other days of the week. He argues than an individual would prefer a smooth consumption flow per day rather than plenty of consumption today and little consumption tomorrow. Thus consumption in one day is not determined by income received on that particular day. Instead, it is determined by average daily income received for a period. Thus, according to him, people plan their consumption on the basis of expected average income over a long period which Friedman calls permanent income”[1].

It may be noted that permanent income or expected long-term average income is a long run concept and includes earning from both human and non-human wealth.

To reconcile the short run and long run consumption functions using the permanent income hypothesis, let us consider an economy over the business cycle we are assuming that the nations output increases over time but output does not grow at a steadily. It has to peak and then decline. The fluctuation in output economic activity in general are called business cycle. When output is at its highest level, the business cycle is set to be at the peak when the output is at its lowest level the business cycle is at its drought. Since permanent income is a long run concept, it does not vary to the same degree as actual income over a business cycle consequently, when the business cycle at the peak, actual income is greater than permanent income because transitory income is positive. Since the MPC from transitory income (Yt) is zero[2], households do not alter there expenditure plans, consequently, consumption is not proportions to actual income at the peak. It is less than proportional.

At the decline, the situation is reversed. Actual income is less than permanent income. Since the actual income is less than the permanent income, transitory income is negative. Since MPC from transitory income (Yt) zero, households do not reduce their consumption, instance, they reduce their savings as a result, consumption is more than proportional to actual income. [3].

The key to permanent income hypothesis is the assumption that transitory income (Yt) and transitory consumption (Ct) are unrelated[4]. This assumption implies that permanent consumption (Cp) is related to permanent income (Yp) as the unexpected additions or subtractions in income and consumption over a long period get cancelled out and permanent consumption (Cp) varies in proportion to permanent income (Yp), such that APC = MPC.

1) To test the pattern of consumption in Tamil Nadu with reference to permanent...

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9. JEFFREY C. FUHRER April, 2000 Habit Formation in Consumption and Its Implications for Monetary Policy Models, Federal Reserve Bank of Boston
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