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Journal ArticleDOI

A retrospective on friedman's theory of permanent income*

01 Jun 2004-The Economic Journal (Institute for Fiscal Studies)-Vol. 114, Iss: 496, pp 293-306
TL;DR: Friedman's Permanent Income Hypothesis (PIF) is one of the great works of economics as mentioned in this paper, and it has been used extensively in modern economics and discusses some relevant empirical results and the way they relate to the original approach.
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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Content maybe subject to copyright    Report

A RETROSPECTIVE ON FRIEDMANS
THEORY OF PERMANENT INCOME
Costas Meghir
THE INSTITUTE FOR FISCAL STUDIES
WP04/01

A Retrospective on Friedman’s Theory of Permanent Income
Costas Meghir
1
University College London and Institute for Fiscal Studies
November 2002
This Version January 2004
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.
1
Acknowledgements: This article was prepared for a conference in honour of Milton Friedman at the
University of Chicago in November 2002, on the occasion of his 90
th
Birthday. I thank the organisers for
the invitation. I also thank Orazio Attanasio, Richard Blundell, Martin Browning, Jim Heckman, Hide
Ichimura, an anonymous referee and colleagues at IFS and UCL for useful discussions that helped me
organise this presentation. I am of course responsible for all errors and interpretations.

Introduction
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. 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. In this
short article I trace out some of the research relating to the Permanent Income Hypothesis
(PIH), particularly that which has been based on microeconomic data, and I demonstrate
the relevance of these ideas for our current way of thinking about consumption, savings
and income processes.
Friedman and Kuznets (1954) “Incomes from Independent Professional Practice” which
was actually written in the early 1940s but delayed in publication, first formulated many
of the ideas of the PIH, including the permanent/transitory decomposition of income in
the volume. The core of these ideas, together with further tests, was brought together in
Friedman’s “Consumption function”. In my review of the PIH I draw mainly from this
latter work.

The Permanent Income Hypothesis
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. In fact the model was developed to explain important empirical facts in a unified
framework. For example, why is income more volatile than consumption and why is the
long run marginal propensity to consume out of income higher than the short run one. To
answer these questions Friedman hypothesized that individuals base their consumption on
a longer term view of an income measure, perhaps a notion of lifetime wealth or a notion
of wealth over a reasonably long horizon. 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. The propensity
itself could vary with a number of factors, including the interest rate and taste shifter
variables, or could reflect uncertainty – we will return to these important insights below.
Friedman set himself the task of testing his hypothesis against an increasing set of
empirical facts from time series data and budget studies. The standard least squares
regression of consumption on income would always point to a marginal propensity to
consume below the average propensity. Conditioning on extra regressors seems to make
things worse. It is at this point that Friedman’s ingenuity, brought together the literature

on budget studies by Margaret Reid, Morgan and others
2
, as well as time series analyses
with Econometric ideas on measurement error to devise estimation techniques, that not
only allowed the testing of the basic hypothesis, but led to the estimation of underlying
parameters that directly characterised the Permanent Income Hypothesis (PIH). As far as
the role of measurement error is concerned the works of great economists and
statisticians of the time, namely Harold Hotelling
3
and James Durbin, influenced
Friedman. He brings together empirical results and statistical theory, and develops new
results by combining these with his economic ideas.
The ingredients of Friedman’s model are permanent consumption (
p
c
), permanent
income (
p
y ), transitory consumption (
t
c ), transitory income (
t
y ). Measured income is
the sum of
permanent and transitory income (
t
y
) and measured consumption is the sum
of
permanent and transitory consumption (
t
c
), i.e.
tp
ccc +=
and
tp
yyy +=
Permanent consumption is determined by the equation
pp
yzrkc ),(=
where
),( zrk is the average (or marginal) propensity to consume out of permanent
income which depends on the rate of interest and on taste shifter variables z. The
2
See Reid (1952) and Morgan (1951).
3
See Hotelling (1933) and Friedman (1992) on the regression fallacy.

Citations
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Journal ArticleDOI
TL;DR: In this article, a survey of available literature on savings-income functions in developing countries is presented, highlighting the concept of savings and some empirical studies done in the area of saving-income relationships and their findings as well as economic implications.
Abstract: The paper is a survey of available literature on savings-income functions in developing countries. It gives critical examination of some of the major theories underlying savings and income functions. In doing this, the paper highlighted the concept of savings and some empirical studies done in the area of savings-income relationships and their findings as well as economic implications of the findings. The import of the paper stems from the fact that domestic savings of which household savings is an important component has contributed immensely to the economic transformation of some economies and the determinants of such savings well researched. Hence, understanding the theoretical underpinnings of the savings-income relationships would pave way for further studies to be conducted in Ghana, thereby, replicating such success stories. This is because a better understanding of the savings-income relationship will contribute to the formulation of appropriate policies for savings mobilisation, thereby improving upon local capital formation capacity. Moreover, a good knowledge gained of the savings-income phenomenon particularly at the rural household level in Ghana will give the monetary authorities a fair idea of how the rural economy operates and how to make improvements in this sector to enable its integration into the mainstream financial system.

5 citations


Cites background from "A retrospective on friedman's theor..."

  • ...This assumes that households are able to determine what their long-term consumption needs are and then apportion their resources accordingly in order to cover their life span (Carroll, 2001; Meghir, 2002)....

    [...]

31 Dec 2015
TL;DR: In this paper, Atallah and El-Komi, Assistant Professors of Economics, American University in Cairo, dedicated the time they dedicated to read my research and give me valuable comments.
Abstract: First and foremost, thanks Allah for granting me the strength, patience and persistence throughout my master’s journey. I am deeply grateful to my supervisor Dr. Samer Atallah, Assistant Professor of Economics, American University in Cairo, for his valuable guidance, encouragement and support throughout this research. It honors me to work under his supervision. I would like to thank my readers, Dr. Mohammed Bouaddi and Dr. Mohamed El-Komi, Assistant Professors of Economics, American University in Cairo, for the time they dedicated to read my research and give me valuable comments. I owe my sincere gratitude to Dr. Adel Beshai, Professor of Economics and Director of Graduate Studies, American University in Cairo, for supporting me during my study period and for being such a great professor and adviser. Last but not least, I am grateful to my family and friends who continuously supported me. This study would not have been possible without their support, love and care.

5 citations


Cites background from "A retrospective on friedman's theor..."

  • ...For instance, it was found that the poor consume at their subsistence level, yet they often have little saving to smooth consumption in case of income shocks (Schmidt-Hebbel, Webb, & Corsetti, 1992; Meghir, 2004)....

    [...]

  • ...Consumption is based on long-term expectations about income since households prefer to smooth consumption over time and avoid short-term fluctuations (Meghir, 2004)....

    [...]

  • ...The implication of permanent income hypothesis is that individuals do not consume transitory income (𝑀𝑃𝑆𝑇 = 1) so temporary changes in transitory income will directly affect household saving (Schmidt-Hebbel et al., 1992; Meghir, 2004)....

    [...]

  • ...The implication of permanent income hypothesis is that individuals do not consume transitory income (MPST = 1) so temporary changes in transitory income will directly affect household saving (Schmidt-Hebbel et al., 1992; Meghir, 2004)....

    [...]

Journal ArticleDOI
TL;DR: In this article, the authors show how the work of Nobel Laureates in economics can be used to enhance student understanding and bring students up to date on topics such as probability, uncertainty and decision theory, hypothesis testing, regression to the mean, instrumental variable techniques, discrete choice modeling and time-series analysis.
Abstract: Undergraduate students typically are able to regurgitate basic rules and formulas for probability. They also have little trouble following the cookbook steps for estimation and hypothesis testing. Microsoft Excel has empowered them to run regressions. We are not persuaded, however, that these advances have markedly improved student understanding of the underlying principles of statistics. Nor are we convinced that advances made by scholars working with quantitative methods and real economic data are making their way into classrooms and computer laboratories. In this piece, we show how the work of Nobel Laureates in economics can be used to enhance student understanding and bring students up to date on topics such as probability, uncertainty and decision theory, hypothesis testing, regression to the mean, instrumental variable techniques, discrete choice modeling and time-series analysis.

4 citations


Additional excerpts

  • ...(See Meghir, 2004.)...

    [...]

Journal ArticleDOI
TL;DR: In this paper, the authors empirically test the effect of unemployment on housing prices in Singapore and Hong Kong using a cross-city analysis, and the results show that, unlike Hong Kong, Singapore's rate of unemployment has no statistical significant effect on house prices.
Abstract: Although many studies have found that unemployment has a negative effect on housing prices, the explanation put forward for this effect, that is, uncertainty over the ability to repay long-term mortgage loans, has not been empirically tested. This paper attempts to empirically test this explanation using a cross-city analysis. Singapore and Hong Kong have been chosen because they are both compact cities and are similar in many aspects. The exception is that Singapore has an established system of home financing from the Central Provident Fund, thereby enhancing greater certainty over the ability to repay long-term mortgage loans. Macro-economic factors, including unemployment rate, were analysed from 1993Q1 to 2003Q4 for Singapore and from 1985Q1 to 2000Q4 for Hong Kong. The results show that, unlike Hong Kong, Singapore's rate of unemployment has no statistical significant effect on housing prices. This study has confirmed the financial constraints hypothesis in the permanent income hypothesis study.

4 citations


Cites background from "A retrospective on friedman's theor..."

  • ...Challenging the assumptions of the model, the income uncertainty hypothesis and financial constraints hypothesis have been raised to explain the discrepancy (Madsen & McAleer, 2000; Meghir, 2004)....

    [...]

Journal Article
TL;DR: In this article, the authors examined the effect of transitory income shocks on different categories of household expenditures, focusing on spending on essential goods and services such as food, health and education in rural Kenya.
Abstract: Majority of rural households in developing economies derive their livelihoods from agriculture, a sector that is highly prone to transitory shocks. In the absence of effective coping mechanisms, these households are unable to smoothen consumption and are thus likely to experience fluctuations in consumption expenditures. This study examines the effect of transitory income shocks on different categories of household expenditures, focusing on spending on essential goods and services such as food, health and education in rural Kenya. The study explores the heterogeneity in households and consumption to test the permanent income hypothesis using a sample of 5,828 rural households disaggregated along two distinct agro-ecological zones. Decomposing household income into permanent and transitory components failed to yield distinct estimates of permanent and transitory incomes when applied to this study’s data. We therefore modified the estimation approach to capture the effect of transitory income shocks by introducing a dummy of crop loss in the household expenditure equation. Our results show that in the countrywide sample, households that experienced crop loss had a statistically significant reduction in the aggregate, food and non-food expenditures compared to the ones that did not. For the high and medium potential agro-ecological zones sample, we found that consumption expenditures were not associated with crop loss. In the arid and semi-arid zones sample, aggregate and food expenditures reduced for households affected by crop loss. The findings provide a basis of policy recommendations on the need for the existing government poverty alleviation programmes to focus on drivers of impoverishment such as transitory income shocks. Keywords: transitory income shocks, consumption expenditure, agro-ecological zones, Kenya DOI : 10.7176/JESD/10-12-04 Publication date :June 30 th 2019

4 citations


Cites background from "A retrospective on friedman's theor..."

  • ...Meghir (2004) found that the propensity to consume is affected by household demographic characteristics such as the number and age composition of the household members, which dictate the consumption needs and preferences over time....

    [...]

References
More filters
Book
01 Jan 1936
TL;DR: In this article, a general theory of the rate of interest was proposed, and the subjective and objective factors of the propensity to consume and the multiplier were considered, as well as the psychological and business incentives to invest.
Abstract: Part I. Introduction: 1. The general theory 2. The postulates of the classical economics 3. The principle of effective demand Part II. Definitions and Ideas: 4. The choice of units 5. Expectation as determining output and employment 6. The definition of income, saving and investment 7. The meaning of saving and investment further considered Part III. The Propensity to Consume: 8. The propensity to consume - i. The objective factors 9. The propensity to consume - ii. The subjective factors 10. The marginal propensity to consume and the multiplier Part IV. The Inducement to Invest: 11. The marginal efficiency of capital 12. The state of long-term expectation 13. The general theory of the rate of interest 14. The classical theory of the rate of interest 15. The psychological and business incentives to liquidity 16. Sundry observations on the nature of capital 17. The essential properties of interest and money 18. The general theory of employment re-stated Part V. Money-wages and Prices: 19. Changes in money-wages 20. The employment function 21. The theory of prices Part VI. Short Notes Suggested by the General Theory: 22. Notes on the trade cycle 23. Notes on mercantilism, the usury laws, stamped money and theories of under-consumption 24. Concluding notes on the social philosophy towards which the general theory might lead.

15,146 citations

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TL;DR: In this paper, the theory of interest was restated and the output of capital goods and of consumption was analyzed in terms of uncertainty and fluctuations of investment, and demand and supply for output as a whole.
Abstract: I. Comments on the four discussions in the previous issue of points in the General Theory, 209. — II. Certain definite points on which the writer diverges from previous theories, 212. — The theory of interest restated, 215. — Uncertainties and fluctuations of investment, 217. — III. Demand and Supply for output as a whole, 219. — The output of capital goods and of consumption, 221.

5,476 citations

Journal ArticleDOI

5,379 citations


"A retrospective on friedman's theor..." refers methods in this paper

  • ...…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…...

    [...]

Journal ArticleDOI
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5,069 citations


"A retrospective on friedman's theor..." refers background in this paper

  • ...…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....

    [...]

Frequently Asked Questions (1)
Q1. What have the authors contributed in "A retrospective on friedman’s theory of permanent income" ?

The authors present a short review of Friedman ’ s Permanent Income Hypothesis, the origins of the idea and its theoretical foundations. The authors 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. This article was prepared for a conference in honour of Milton Friedman at the University of Chicago in November 2002, on the occasion of his 90 Birthday.