A retrospective on friedman's theory of permanent income*

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

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.

Figures

Table 1 The nature of permanent income and the estimation of the time series properties of income

Full text

A RETROSPECTIVE ON FRIEDMAN’S
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.

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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.