Permanent Income Hypothesis

Like Duisenberg, Milton Friedman and Franco Modigliani argue that consumption function is essentially proportional, i.e., there is no tendency for the proportion of income saved to increase at higher income levels. They, however, believe that households do not adapt the their consumption behavior to their current income alone, but to a general level of their resource over extended period of time. This is called Permanent Income Hypothesis. Modigliani’s theory of consumption, which is called Life Cycle Theory is similar to the permanent Income theory of Friedman.

A family’s permanent income in any period is not indicated by its current income but is determined by the expected or anticipated income to be received over a long period of time extending over a number of years. A family’s actual income. which Friedman calls the ‘measured income’ in any one year may be larger or smaller than the permanent income The income of particular year, i.e., the measured income can be divided into two parts, viz., the permanent income and the transitory income. The measured income can be larger or smaller than the permanent income depending upon whether the net transitory income is positive or negative. For Example, if a wage earner gets some prize money during the current period and that the does not hope to get the same in the following years.

Similarly, if a strike or a lockout makes him suffer an unexpected loss of income for some time, it’s a negative transitory income that reduces this measured income of the current year below the level of his permanent income. These unforeseen additions to or subtractions from the family income are expected to cancel out over a longer period of time and are thus not relevant to permanent income.

In the same way measured consumption, i.e., consumption during the current year under study can be divided into two components, viz., permanent consumption and transitory consumption. Any goods purchased because of some exceptionally attractive sale price is a positive transitory consumption and raises the measured consumption above the level of permanent consumption. Similarly, postponement of purchase due to non-availability of goods at present is a negative transitory consumption that reduces measured consumption below the level of permanent consumption.