Permanent Income hypothesis

November, 2017- Paper III
Question no.14
Permanent Income hypothesis assumes positive correlation between which of the following pairs of variables?
a) Permanent income and transitory income
b) Permanent income and transitory consumption
c) Permanent income and permanent consumption
d) Transitory income and transitory consumption
Answer C
Nobel award winning economist, Milton Friedman postulated Permanent Income Hypothesis in the year 1957. Permanent income hypothesis states that a person’s consumption in a year is determined by not just by their income in the respective year but also their expected income in future years, known as the permanent income. Thus, permanent income is that steady level of income which the person expects to last for his life time.
Permanent income consists of any current income and expected changes in future income, such as future promotions or getting fired. So, current incomes are added up with future changes known about income and averaged out to figure out permanent income. This determines how much a household should consume according to a long-term average.
Transitory income is a temporary or unexpected form of income. It could consist of someone winning the lottery because not many people expect to win the lottery nor does it happen often so it is highly unlike to win the lottery more than once. In Friedman’s theory, transitory income is supposed to turn into savings.
Permanent consumption is consumption determined by permanent income. Transitory consumption may be interpreted as unanticipated consumption, such as unexpected medical emergencies. Friedman assumes that there is no relationship between transitory and permanent income, between transitory and permanent consumption, and between transitory consumption and transitory income. It implies that transitory income is random with respect to permanent income and that transitory consumption is independent of permanent consumption. Also, transitory consumption is random with respect to transitory income, which implies that the marginal propensity to consume from transitory income is zero. This means that a household fortunate enough to receive positive transitory income will not alter its consumption (which is based on permanent income). Instead, the household will save the additional income. Similarly, if a household is unlucky enough to receive negative transitory income, it will not reduce its consumption. Rather, it will reduce its saving.