01/05/2023 Prabha Panth

Theories of Consumption - II

Prof. Prabha Panth,Osmania University,

Hyderabad

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01/05/2023 Prabha Panth

III. Permanent Income Hypothesis – Milton Friedman

According to Friedman: Actual Y is made up of: (a) Permanent Y and (b)

Transitory YY = YP + YT

YT includes unexpected Y, interest, prizes, lotteries, etc. People base their consumption on ‘Permanent Y’ which is

constant and sure. C from YP is constant, even if YT changes in different time

periods. YT may change in the short run, but YP remains constant in

the long run.2

01/05/2023 Prabha Panth

Short term fluctuations in Y are temporary, and will not affect C.

Actual Y = YP + YT (expected future Y)

C = a + bYP + cYT

Short run: temporary income may not lead to C. APC, but APS

Long run: C is based on permanent Y, so as YP , APC is constant.

Consumers base their permanent C on permanent Y, so APC = MPC = constant.

This C-function starts from the origin (0).

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01/05/2023 Prabha Panth

Permanent Y hypothesis – Milton Friedman

C,S

0 Y

Long run C

Short run C1

Y1

E1

Short run C2E2

Y2

APC falls as temporary Y increases

Long run, APC=MPC constant

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01/05/2023 Prabha Panth

IV. Life cycle Hypothesis - Modigliani Long period C is related to life time

average Y. It does not respond to changes in

current Y. Consumption depends on:

Wealth: Present value of all current and future

earnings, Rate of return to capital, Age of the consumer

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01/05/2023 Prabha Panth

Life cycle – Age of the Population influences C and S

Y,C

0 Time

C

C1

Y

Y1

Youth

S< 0

18 years 60 years

Working Years

S>0

Old Age

S<0

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01/05/2023 Prabha Panth

Up to 18 years (youth), C>Y, so S <0. APC as Y

Between 18 to 60 are working years, Y > C and S > 0. Here C/Y constant.

After 60 years, old age, Y < C, and so S <0 (C/Y)

In second phase, present C is maintained, and debt of youth is cleared off.

Further reserve savings are accumulated for the future.

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01/05/2023 Prabha Panth

The dependence structure of the population influences consumption pattern.

So S and Y are not proportional.

At the empirical level, data shows that population age distribution affects aggregate consumption and savings.

This is the Life Cycle hypothesis of Modigliani.

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