permanent income hypothesis
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
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