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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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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
More filters
01 Dec 2009
TL;DR: In this article, a comparative analysis of the determinants of household savings behavior in China, India and South Africa, with specific reference to the consumer behaviour of the middle class consumer in each country is presented.
Abstract: High levels of gross national savings reduce a country’s reliance and exposure to the vagaries of the global capital market. On an individual level, delaying consumption and providing for future needs and prosperity is a necessary condition to improve or maintain the quality of life. India and China’s gross national savings and, in particular, their household savings rates are higher than those of South Africa. Within the context of sustaining the global competitiveness of these developing countries each with a burgeoning middle class – there is a need to ensure that policy formulation recognises the consumption and savings needs of this segment of the population. With a view to understanding the reasons why the household savings rates of China and India are so high in comparison to South Africa, this report investigates whether (and to what extent) South African policy makers can learn from China and India in the design of its policy framework to reduce consumption and create a savings culture. This research project is a comparative analysis of the determinants of household savings behaviour in China, India and South Africa, with specific reference to the consumer behaviour of the middle class consumer in each country. The comparative analysis draws on secondary sources such as journal articles, books, completed research and the Internet. While India and China have high household savings rates, this is not as a function of policy reforms that were introduced to encourage saving. Rather, an absence of sufficient financial sector development and a weak social safety net, coupled with a collective household culture and attitude that values saving ahead of consumption, that has resulted in households in India and China, and in particular middle income households, saving to ensure adequate provision is made. In South Africa, the impacts of financial liberalisation and a flawed social security system have resulted in a failure to provide broad based income protection. Increased consumer access to financial services coupled with a coherent social security structure and continued government investment are critical threads that must pervade the reform agenda in South Africa.

12 citations

Journal ArticleDOI
TL;DR: In this article, the authors proposed a two-step aggregation method for measuring long-term income inequality and income mobility, where mobility is defined as an equalizer of longterm income, and they employed an axiomatic approach to justify the introduction of a generalized family of rank-dependent measures of inequality, where the distributional weights, as opposed to the Mehran-Yaari family, depend on income shares as well as on population shares.
Abstract: This paper proposes a two-step aggregation method for measuring long-term income inequality and income mobility, where mobility is defined as an equalizer of long-term income. First, the income stream of each individual is aggregated into a measure of permanent income, which accounts for the costs associated with income fluctuations. Consequently, mobility will have an unambiguously positive impact on social welfare in the sense that for two societies that have identical short term income distributions, the social welfare will be greatest for the society which exhibits most mobility. The second step consists of aggregating permanent incomes across individuals into measures of social welfare, inequality and mobility. To this end, we employ an axiomatic approach to justify the introduction of a generalized family of rank-dependent measures of inequality, where the distributional weights, as opposed to the Mehran-Yaari family, depend on income shares as well as on population shares. Moreover, a subfamily is shown to be associated with social welfare functions that have intuitively appealing interpretatio ns. Further, the generalized family of inequality measures provides several new interpretations of the Gini-coefficient. The proposed family of income mobility also proves to encompass standard measures of income mobility, depending on the assumptions made about the interpersonal preferences and the credit market.

12 citations

Journal ArticleDOI
TL;DR: This article argued that the marginalization of absolute and relative income hypotheses was due to the dominance of a specific methodological framework that did not favour such approaches, and argued that such approaches were marginalized not because of their empirical or theoretical shortcomings, but because of emphasizing the psychological and social influences on consumption patterns, and because of not employing the intertemporal utility maximizing framework.
Abstract: In Keynes’ consumption theory absolute income is the major determinant of consumption, and the marginal propensity to consume determines the magnitudes of fiscal multipliers. Keynes employed a largely psychological analysis of consumption, rejecting the model of utility maximizing consumer. J. Duesenberry extended and improved Keynes’ approach by also emphasizing the role of psychological and social factors on consumption decisions (the relative income hypothesis). Similar conclusions regarding the role of income on consumption, and therefore support for Keynesian policies, are reached by Duesenberry’s analysis. The life-cycle hypothesis by Modigliani and Brumberg (1954), and the permanent income hypothesis by Friedman (1957), emerged as the two main alternatives to Keynes’ and Duesenberry’s approaches. Modern orthodox consumption theories are extensions of these two theories in a rational expectations framework. By employing the concept of forward looking, optimizing agents, current or relative income plays a minimal role in the life-cycle and permanent income hypotheses, and an even lesser role in contemporary orthodox consumption theories. Consequently, fiscal policy has a negligible effect on output and employment. The paper argues that Keynes and Duesenberry’s approaches were marginalized not because of their empirical or theoretical shortcomings, but because of emphasizing the psychological and social influences on consumption patterns, and because of not employing the intertemporal utility maximizing framework. The clear implication of the discussion is that the marginalization of absolute and relative income hypotheses was due to the dominance of a specific methodological framework that did not favour such approaches.

11 citations


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

  • ...(Meghir 2004, 297n) The same attitude is expressed in contemporary DSGE models: the standard Keynesian model is “theoretically unacceptable because its underlying equations are not microfounded.”...

    [...]

  • ...Over the long run, income variation is due mainly, if not solely, to variation in permanent income, which in addition to equality between APC and MPC, implies a stable and less than 1 APC (Chao 2003; Meghir 2004)....

    [...]

  • ...The key point is that the consumption plan does not depend on the transitory components (for a detailed discussion, see Chao 2003 and Meghir 2004)....

    [...]

  • ...In fact, the permanent-income hypothesis is a special case of an intertemporal optimisation model of consumer behaviour, where agents maximise the sum of their expected utility subject to a life-time budget constraint (Meghir 2004)....

    [...]

  • ...Thus, in the long-run observed levels of income (Y) are equal to permanent income (YP) (Friedman 1957; see also Meghir 2004)....

    [...]

Journal ArticleDOI
TL;DR: In this paper, a strong linear relationship exists between income and house price quantiles in Sydney (Australia), Houston, and the state of Texas, which suggests that the house price distribution is closely approximated by the income distribution after a location-scale transformation.
Abstract: We show that a strong linear relationship exists between income and house price quantiles in Sydney (Australia), Houston, and the state of Texas. This suggests that the house price distribution is closely approximated by the income distribution after a location-scale transformation. The slope of the line changes over time in response to changes in the mortgage market. We argue that this finding is consistent with a simple variant on the permanent income hypothesis. We then explore some of the implications with regard to the evolution of house prices, price-to-income ratios, the efficiency of the housing market, the construction and interpretation of hedonic price indexes for housing, and for public policy.

11 citations


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

  • ...Replacing permanent income with observable income causes attenuation bias in the estimated slope coefficient [see Friedman (1957) and Meghir (2004)]....

    [...]

Journal ArticleDOI
TL;DR: In this paper, the authors carried out a detailed historic analysis of various theories developed within household economics and personal finance; assessing their applicability and efficiency in solving the household expenditure management problems; and offering alternative approach to expenditure management, which reduces the influence of subjective factors compromising quality of decision making within expenditure management.
Abstract: Purpose of the article The study aims at: a) carrying out a detailed historic analysis of various theories developed within household economics and personal finance; b) assessing their applicability and efficiency in solving the household expenditure management problems; c) offering alternative approach to expenditure management, which reduces the influence of subjective factors compromising quality of decision making within expenditure management. Methodology/methods. Cross-disciplinary approach integrating psychology and economics, Maslow theory of needs, vector algebra, utility optimization, case study based testing. Scientific aim. To justify theoretically the principles enabling development of alternative approach to household expenditure management based on decomposition of the aggregate value of goods/services into components, each reflecting a certain level of Maslow’s pyramid of needs; quantitatively evaluate and compare the value components representing different levels of the pyramid and estimate the respective cost of consumer’s needs. Findings. The decomposed value components better than the aggregate value reflect the ability of good/service to satisfy various complex needs of the consumer, both basic (physiological) and those purely psychological from higher stages of the pyramid of needs, e.g. esteem and self-actualization. Decomposition gives the possibility to quantitatively evaluate and compare them. Results of case studies carried out have proved validity of the approach and the potential in being applied as a planning tool in managing household expenditure. Conclusions. Decryption of the aggregate value of goods and services by using decomposition creates a platform for development alternative approach to expenditure management in households, less dependant on subjective, intuition based decisions. It could yield to reduction of spontaneous spending, give the possibility to harmonize not only total/aggregate consumption with the income, but also to find a balance between items in the bunch of products/services purchased, thus preventing an unbalanced (excessive or insufficient) allocation of funds. DOI: http://dx.doi.org/10.5755/j01.ee.26.5.13066

10 citations


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

  • ...It provides an explanation for some of the failures of Keynesian demand management techniques (Friedman, 1957; Meghir, 2004)....

    [...]

References
More filters
Book
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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.

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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.

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"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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Abstract: Youruse of the JSTOR database indicates your acceptance of JSTOR’s Termsand Conditions of Use. A copy of JSTOR’s Terms and Conditions of Useis available at http://www.jstor.ac.uk/about/terms.html, by contacting JSTORatjstor@midas.ac.uk, or by calling JSTOR at 0161 275 7919 or (FAX) 0161 275 6040. Nopart ofaSTOR transmission may be copied, downloaded,stored, further transmitted, transferred, distributed, altered, or otherwise used, in any form or by any means, except: (1) one stored electronic and one paper copy ofanyarticle solely for your personal, non-commercial use, or (2) with prior written permission of JSTOR andthe publisher of the article or other text.

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.