# A retrospective on friedman's theory of permanent income*

Abstract: Friedman’s book on the “Consumption Function” is one of the great works of Economics demonstrating how the interplay between theoretical ideas and data analysis could lead to major policy implications. We present a short review of Friedman’s Permanent Income Hypothesis, the origins of the idea and its theoretical foundations. We give a brief overview of its influence in modern economics and discuss some relevant empirical results and the way they relate to the original approach taken by Friedman.

## Summary (2 min read)

### Introduction

- The theory of the Consumption function played an important role in explaining why traditional Keynesian demand management, through transitory tax policy or other transitory income boosting measures can have little or no effect on real consumption and on the desired policy outcomes.
- The apparently simple ideas in this excellent book have been so insightful and powerful that they have given rise to a huge amount of research, both theoretical and empirical, which continues to this date.
- Particularly that which has been based on microeconomic data, and I demonstrate the relevance of these ideas for their current way of thinking about consumption, savings and income processes.

### A statement of the Hypothesis

- Milton Friedman’s PI hypothesis originates from the basic intuition that individuals would wish to smooth consumption and not let it fluctuate with short run fluctuations in income.
- The basic hypothesis posited is that individuals consume a fraction of this permanent income in each period and thus the average propensity to consume would equal the marginal propensity to consume.
- He brings together empirical results and statistical theory, and develops new results by combining these with his economic ideas.
- By comparing averages over time or across different groups of individuals, Friedman is implicitly using Instrumental variables, now a well recognised technique for dealing with classical measurement error in linear models.
- Wald (1940) suggested comparing group averages to overcome measurement error, although the way he approached grouping was not quite right.

### The notions of Permanent Income

- The PIH provides a flexible framework for the study of consumption and savings.
- Much of the subsequent research has filled in those elements necessary for explaining aspects of the data, thus defining the agenda for research on consumption and savings.
- The basic hypothesis requires a rolling horizon, which allows some degree of smoothing of consumption.
- The flexibility of the hypothesis comes at a price, since it is hard to define the theoretical underpinnings of the model, and consequently it is hard to make more detailed statements about policy.
- Friedman points this out in the Consumption function book when he states that that permanent income is best defined “… to be whatever seems to correspond to consumer behaviour.”.

### The theoretical foundations of the PIH

- There have been other attempts to explain consumption behaviour.
- The key implication of this model ttt E R cU λ β =)(' is that the marginal utility of consumption in each period is equal to the expected marginal utility of wealth multiplied by a factor depending on the interest rate and the rate of time preference.
- Whether this will be detectable in the data will depend on the proportion of individuals who are thus constrained.
- This is not too say that this is not important, but to lay the ground for arguing that a more general version of the PIH, with similar foundations is in fact consistent with the data, although the version of the PIH developed here is probably too restrictive.

### Risk aversion, and the PIH

- Given that markets are never found to be complete (e.g. Cochrane, 1991) and Attanasio and Davis, 1996) and given aggregate uninsurable shocks this must be a central issue.
- While these ideas were not formalised at the time they turn out to be key elements in demonstrating that some generalised version of the PIH does in fact fit the data very well and can explain observed consumption patterns.
- It may for example be reasonable to think that more consumption is shifted towards the household when it consists of more members.
- Heckman (1974) pointed out that if consumption is not additively separable from hours of work and this is ignored, the resulting consumption choices over time will look as if they track income, in a way that would reject the basic premise of the permanent income hypothesis.
- The study of income processes has been motivated in part by the study of consumption and savings because it has become apparent that knowing the time series properties of income may be informative about consumption behaviour.

### Conclusions

- Most important discoveries and insights are simple, economical, have important implications for a broad range of issues and withstand the test of time.
- Moreover, they generate large amounts of research, verifying it and refining it.
- This is exactly the case with Friedman’s PIH.
- At the end of all this, the original idea has not only survived, but has formed the basis for developing a coherent analysis of consumption and savings.

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...Townsend (1994) tested the full insurance hypothesis in the development context and a body of research has emerged on this theme (see Ravallion and Chaudhuri, 1997; Bardhan and Udry, 1999 for an overview)....

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...In a parallel literature, various empirical specifications of the Permanent Income Hypothesis have been tested (Friedman, 1957; for a review, see Meghir, 2004), and its insights have become widely used in models of intertemporal choice investigating whether and how consumption is smoothed when…...

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...…of the Euler equation approach for the study of savings and consumption, the introduction of Rational expectations in economic modelling and the Lucas (1976) critique, provided both the motivation and the means by which to develop tests of the PIH that did not involve measuring PI, at least…...

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...…appeal, it is a special case of an intertemporal optimisation model of consumer behaviour, which is the most coherent and logically consistent model we have at present.3 This model has its roots in the works of Fisher (1907) and Ramsey (1928) and has since been developed in many directions....

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