Permanent Income Hypothesis Introduction
The basic idea is that people’s income has a random element to it and also a known element to it and that people try to smooth the random part using saving and borrowing. Hence, we need to distinguish between permanent income and transitory income.
Example: Suppose that you are working and receive an annual salary of twenty thousand dollar. Suppose that you expect to get that salary every year in the future. Then twenty thousand dollar represents the permanent part of your income and you expect to get twenty thousand dollar every year also in the future. However assume that this year, since you have been very productive, you receive a bonus of five thousand dollar. This bonus represents a transitory income since you do not expect to get it every year from now on. In particular permanent changes in income lead to much larger changes in consumption than temporary income changes. Thus, permanent income changes are mostly consumed while temporary income changes are mostly saved. For example, if you get promoted and you get a salary increase, this change will be probably permanent and so your consumption over time will probably rise. If instead you win the lottery, this represents a transitory income and you will probably not consume all of this transitory income.
The key point is that the consumption plan does not depend on the transitory components. To provide empirical content to this hypothesis, Friedman added the assumptions that the transitory components are uncorrelated (i.e interdependent) to each other and uncorrelated (i. e independent) to the permanent component. The Permanent Income Hypothesis assumes the absence any correlation between YP and YT, between CP and CT, or between YT and CT.
This figure presents the historical record of the relationship between income and consumption for the United States from 1950 to 1993.On the y axis there is real personal consumption expenditures and on the x axis there is real disposable income. It gives real disposable income for the entire nation and actual real personal consumption for the entire country. A line has been drawn to all the dots to show the so-called fitted consumption function. All the points fall to the right of the 45-degree reference line. The long-run consumption function in Figure here shows a marginal propensity to consume of about 0.9. The average propensity to consume is also 0.9. Hence, from past data it is found that in the absence of autonomous consumption in the long run MPC equal APC both of permanent income. Thus, solving the consumption puzzle. However, this is not to imply that the APC of every individual is equal. In fact the model was developed to explain important empirical facts in a unified framework. For example, why is income more volatile than consumption and why is the long run marginal propensity to consume out of income higher than the short run one. Now Ameerah will further elaborate on the empirical evidences of permanent income hypothesis
Empirical Evidence of PIH (Ameerah)
Friedman set himself the task of testing his hypothesis against an increasing set of empirical facts from time series data and budget studies. The standard least squares regression of consumption on income would always point to a marginal propensity to consume below the average propensity. Conditioning on extra regressors seems to make things worse. It is at this point that Friedman’s ingenuity, brought together the literature on budget studies by Reid (1952), Morgan (1951) and others, as well as time series analyses with econometric ideas on measurement error to devise estimation techniques, that not only allowed the testing of the basic hypothesis, but led to the estimation of underlying parameters that directly characterised the Permanent Income Hypothesis (PIH). We use the graphs in Figure 1 (taken from Blundell et al., 1994) to show intuitively why allowing for changes in...
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