A Theory of the Consumption Function by Milton FriedmanReview by: A. AsimakopulosThe Canadian Journal of Economics and Political Science / Revue canadienne d'Economique etde Science politique, Vol. 25, No. 1 (Feb., 1959), pp. 77-79Published by: Wiley on behalf of Canadian Economics AssociationStable URL: http://www.jstor.org/stable/138879 .

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to be entirely unsupported by the authorities .. ." (p. 339). The consequence is that the discussion of short-term capital movements with a flexible rate is confused. While it purports to describe a foreign exchange situation other than an adjustable-peg system, it does not, as is evidenced by the rhetorical question (p. 385): "Is it really likely that speculation against sterling would have been

very much less in 1949 had $4.03 been, not a fixed rate, but a level at which the pound was being temporarily supported by the authorities?" It would not be likely, but then, it is also unlikely that the rate would have been $4.03. It is noteworthy that Canadian experiences with a flexible rate are nowhere discussed.

Failure to perceive that an appropriate policy of exchange rates may make

possible short-run equilibrium in the balance of payments leads MacDougall to advocate discriminatory controls and, as a result, inconvertible currencies. "While inconvertibility may be undesirable in itself . . . it is doubtful whether, without it, there will be enough discrimination to prevent a serious con- traction of non-dollar trade" (p. 365).

HARRY C. EASTMAN

University of Toronto

A Theory of the Consumption Function. By MILTON FRIEDMAN. National Bureau of Economic Research General Series, no. 63. Princeton, N.J.: Princeton University Press. 1957. Pp. xvi, 243. $4.75.

THE consumption function has sparked a great deal of inquiry, both theoretical and empirical, ever since its use by Keynes in the General Theory. Keynes took it for granted that current consumption expenditure is a stable function of current income and that the proportion of income devoted to consumption declines with rising income. Empirical attempts to estimate consumption functions quickly followed Keynes's theoretical treatment. These studies were based on both time series and family budget data, and at first they seemed to confirm Keynes's theoretical hypothesis, but then a serious conflict of evidence arose with the publication of new estimates of savings for the United States since 1899 made by Kuznets. They showed no rise in the percentage of income saved during the past half-century despite a substantial rise in real income. Another indication of the inadequacy of a consumption function relating con- sumption or savings solely to current income was the study of budget data for different periods which showed roughly the same average propensity to con- sume for widely separated dates, despite substantial differences in average real income. Friedman has addressed himself to the problem posed by these conflicting results and his study is very suggestive, a model for this type of analysis. It moves from a theoretical consideration of consumer behaviour as related to the determination of the division of expenditure over time, that is the division of income between consumption and saving, and then proceeds to test the hypothesis indicated by this study against available empirical material.

Friedman's hypothesis relates "permanent consumption" to "permanent income." Permanent income, as opposed to current receipts, is defined as "the amount a consumer unit could consume (or believes that it could) while

to be entirely unsupported by the authorities .. ." (p. 339). The consequence is that the discussion of short-term capital movements with a flexible rate is confused. While it purports to describe a foreign exchange situation other than an adjustable-peg system, it does not, as is evidenced by the rhetorical question (p. 385): "Is it really likely that speculation against sterling would have been

very much less in 1949 had $4.03 been, not a fixed rate, but a level at which the pound was being temporarily supported by the authorities?" It would not be likely, but then, it is also unlikely that the rate would have been $4.03. It is noteworthy that Canadian experiences with a flexible rate are nowhere discussed.

Failure to perceive that an appropriate policy of exchange rates may make

possible short-run equilibrium in the balance of payments leads MacDougall to advocate discriminatory controls and, as a result, inconvertible currencies. "While inconvertibility may be undesirable in itself . . . it is doubtful whether, without it, there will be enough discrimination to prevent a serious con- traction of non-dollar trade" (p. 365).

HARRY C. EASTMAN

University of Toronto

A Theory of the Consumption Function. By MILTON FRIEDMAN. National Bureau of Economic Research General Series, no. 63. Princeton, N.J.: Princeton University Press. 1957. Pp. xvi, 243. $4.75.

THE consumption function has sparked a great deal of inquiry, both theoretical and empirical, ever since its use by Keynes in the General Theory. Keynes took it for granted that current consumption expenditure is a stable function of current income and that the proportion of income devoted to consumption declines with rising income. Empirical attempts to estimate consumption functions quickly followed Keynes's theoretical treatment. These studies were based on both time series and family budget data, and at first they seemed to confirm Keynes's theoretical hypothesis, but then a serious conflict of evidence arose with the publication of new estimates of savings for the United States since 1899 made by Kuznets. They showed no rise in the percentage of income saved during the past half-century despite a substantial rise in real income. Another indication of the inadequacy of a consumption function relating con- sumption or savings solely to current income was the study of budget data for different periods which showed roughly the same average propensity to con- sume for widely separated dates, despite substantial differences in average real income. Friedman has addressed himself to the problem posed by these conflicting results and his study is very suggestive, a model for this type of analysis. It moves from a theoretical consideration of consumer behaviour as related to the determination of the division of expenditure over time, that is the division of income between consumption and saving, and then proceeds to test the hypothesis indicated by this study against available empirical material.

Friedman's hypothesis relates "permanent consumption" to "permanent income." Permanent income, as opposed to current receipts, is defined as "the amount a consumer unit could consume (or believes that it could) while

Reviews of Books Reviews of Books 77 77

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Canadian Journal of Economics and Political Science

maintaining its wealth intact." Permanent consumption also differs from actual

expenditures on goods and services. It designates for a consumer unit "the value of the services that it has planned to consume during the period in question." Permanent consumption therefore differs from the actual expendi- tures used in a statistical study on two counts: first, because of additions to or subtractions from the stock of consumer goods, second, because of divergencies between plans and their realization. Friedman's "permanent income hypothesis" states that the ratio (denoted by k) between permanent consumption and

permanent income is independent of the size of permanent income. This ratio is, however, affected by the rate of interest, the relative importance of property and non-property income and the various factors determining the consumer unit's tastes and preferences for consumption versus additions to wealth. This

hypothesis relates to permanent concepts while all the data refer to measured

magnitudes. The differences between the permanent and measured values, apart from errors of observation, are due to transitory factors. In order to test a theory concerning permanent values when only measured values are avail- able, it is necessary to make some assumption about the relation of permanent to transitory factors. For this purpose Friedman assumes there is no correlation between permanent and transitory components of income and consumption.

The meaning of Friedman's hypothesis can be made clear by summarizing one of his graphical illustrations. Consider a special case where the mean transitory components of income and consumption for a group of consumer units are zero. The consumer units with a particular measured income which is above the mean measured income for the group as a whole are likely to have favourable transitory income effects, whereas units with a measured income below the average are more likely to have unfavourable transitory effects. Given the assumption of zero correlation between transitory income and transitory consumption, the consumption of the units in the first sub-group is less than if their measured income equalled their permanent income and the consumption of the units in the second sub-group is greater than if their measured income equalled their permanent income. Therefore, even if the ratio between permanent consumption and permanent income is constant at all levels of income, the observed relation would show average propensity to consume decreasing with increasing income. Friedman's hypothesis suggests that differences among various groups of consumer units in observed marginal propensities to consume may not reflect differences in underlying preferences for consumption and wealth at all; they may reflect primarily the different strength of random forces, including errors of measurement, in determining measured income.

Friedman examines family budget and time series data to see if his hypothesis is consistent with the available material. The points representing mean income and consumption for eight American budget studies from 1888 to 1950 lie very close to a straight line representing the assumed relation between per- manent components, permanent consumption equals 90 per cent of permanent income; this is a result consistent with Friedman's hypothesis if mean transitory components for each sample are zero. The only point which diverges sub. stantially represents the values for 1944, but in that year of shortages it is

78

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fairly clear that the mean transitory component of consumption was not zero but negative, and the divergency is in the proper direction. Friedman's

hypothesis is then consistent with these data (and with other budget studies he examined). It should be noted that his hypothesis does not require the ratio of permanent consumption to permanent income to be constant over time as it was for the data he examined, because it depends upon a variety of factors which could vary over time. Presumably, there was no difference in these variables for the budget studies, or rather whatever changes occurred were

offsetting ones. The results obtained are perhaps a little too good, and the factors determining k and their possible variation over time would seem to

require further study. Friedman's hypothesis leads him to expect that income elasticity of con-

sumption as computed from time series data will be higher when computed from aggregate than from per capita data, and also higher for current dollar than for deflated income. The examination of consumption function estimates show these predictions to be generally well fulfilled. Thus, Friedman's hypo- thesis is shown to be consistent with time series as well as with budget data.

The acceptance of the permanent income hypothesis has a variety of

implications for future research. It would mean that less emphasis should be attached to regressions of consumption on income and more to finding the

major determinants of k and to measuring their influence. It also means that conclusions drawn from the earlier absolute income hypothesis and from the relative income hypotheses put forward by Dusenberry, Modigliani, and others about saving patterns at low income levels, as well as views on the effect of

inequality of incomes on savings, will have to be revised. A. ASIMAKOPULOS

Royal Military College of Canada

Industry and the State. By P. SARGANT FLORENCE. London: IHutchinson's Uni- versity Library; New York: Rinehart & Company. 1957. Pp. 196. $1.50.

EVERY man has an attitude towards his government: he thinks it right or wrong, interfering too much or too little in the lives of the citizens. Here is a book that deals with the British state's increasing intervention in economic life, particularly as it affects industry. It is a short text, and does not purport to tell us everything, but it is written by a man who speaks from a deep acquaintance with the subject. The author retired in 1955 as Professor of Com- merce at the University of Birmingham, a post he had held since 1929.

Far from accepting the notion that laissez-faire is dead, the author believes that departures from it indicate a new government attitude of, in his words, "laissez collectives faire," by which he means that the British government has intervened to set up new entities which bargain freely among themselves. (Even the managements of nationalized industries act very much the same as other managements.) But there are groups that bargain instead of individuals.

In an interesting and valuable chart (p. 20) Professor Florence lists in- fluences which have contributed to changes in British public opinion over the last fourteen decades. In a parallel column, with dates that indicate a time-lag

fairly clear that the mean transitory component of consumption was not zero but negative, and the divergency is in the proper direction. Friedman's

hypothesis is then consistent with these data (and with other budget studies he examined). It should be noted that his hypothesis does not require the ratio of permanent consumption to permanent income to be constant over time as it was for the data he examined, because it depends upon a variety of factors which could vary over time. Presumably, there was no difference in these variables for the budget studies, or rather whatever changes occurred were

offsetting ones. The results obtained are perhaps a little too good, and the factors determining k and their possible variation over time would seem to

require further study. Friedman's hypothesis leads him to expect that income elasticity of con-

sumption as computed from time series data will be higher when computed from aggregate than from per capita data, and also higher for current dollar than for deflated income. The examination of consumption function estimates show these predictions to be generally well fulfilled. Thus, Friedman's hypo- thesis is shown to be consistent with time series as well as with budget data.

The acceptance of the permanent income hypothesis has a variety of

implications for future research. It would mean that less emphasis should be attached to regressions of consumption on income and more to finding the

major determinants of k and to measuring their influence. It also means that conclusions drawn from the earlier absolute income hypothesis and from the relative income hypotheses put forward by Dusenberry, Modigliani, and others about saving patterns at low income levels, as well as views on the effect of

inequality of incomes on savings, will have to be revised. A. ASIMAKOPULOS

Royal Military College of Canada

Industry and the State. By P. SARGANT FLORENCE. London: IHutchinson's Uni- versity Library; New York: Rinehart & Company. 1957. Pp. 196. $1.50.

EVERY man has an attitude towards his government: he thinks it right or wrong, interfering too much or too little in the lives of the citizens. Here is a book that deals with the British state's increasing intervention in economic life, particularly as it affects industry. It is a short text, and does not purport to tell us everything, but it is written by a man who speaks from a deep acquaintance with the subject. The author retired in 1955 as Professor of Com- merce at the University of Birmingham, a post he had held since 1929.

Far from accepting the notion that laissez-faire is dead, the author believes that departures from it indicate a new government attitude of, in his words, "laissez collectives faire," by which he means that the British government has intervened to set up new entities which bargain freely among themselves. (Even the managements of nationalized industries act very much the same as other managements.) But there are groups that bargain instead of individuals.

In an interesting and valuable chart (p. 20) Professor Florence lists in- fluences which have contributed to changes in British public opinion over the last fourteen decades. In a parallel column, with dates that indicate a time-lag

Reviews of Books Reviews of Books 79 79

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