Friedman Consumption theory
Another solution to the apparent contradiction between the proportional long-run and non-proportional short-run consumption function is Friedman’s permanent income hypothesis. Friedman rejects the use of “current income” as the determinant of consumption expenditure and instead divides both consumption and income into “permanent” and “transitory” components, so that
Ym or Y Yq+Y(1) and C-C+C (2)
Where P refers to permanent, t refers to transitory. Y to income and C to consumption. Permanent income is defined as “the amount a consumer unit could consume (or believes that it could) while maintaining its wealth intact.”
It is the main income of a family unit which in turn depends on its time horizon and farsightedness. “It includes non-human wealth that it owns, the personal attributes of earners in the unit…the attributes of the economic activity of the earners such as the occupation followed, the location of economic activity, and so on.”
Y being the consumer’s measured income or current income, it can be larger or smaller than his permanent income in any period. Such differences overall effect of these off-setting forces is to raise consumption in proporation to the change in the permanent income component. Therefore, there is a proportional relation between permanent income and consumption,
C-RY (4)
Where k is the coefficient of proportionality in which APC and MPC are endogenous and it depends upon the above mentioned factors. In other words, it is that proportion of fixed income which is consumed. Now take permanent income which is based on time series. Friedman believes that permanent income depends partly on current income and partly on previous period’s income. This can be measured as
YaY (1-a) Y(5)
where Y permanent income in the current period, Y-current income in the current period. Y., previous period’s income, a-ratio of change in income between current period (1) and previous period (t-1).
This equation tells that permanent income is the sum of current period’s income (Y) and previous periods income (Y,) and the ratio of income change between the two (a). If the current income increases at once, there will be small increase in permanent income.
For the permanent income to increase, income will have to be raised.
continuously for many years. Then only people will think that is has increased. By integrating equations (4) and (5), short-run and long-run consumption function can be explained as Where C-current period consumption, ka-short-run MPC. k-long
C-ky-kayt+k(1-a) Y(6)
run MPC and k (1-a) Y,,, is the intercept of short-run consumption function. According to Friedman, k and ka are different from one another and k> ka. Further, k = 1 and ka=0 Equation (6) tells that consumption depends both on previous income and current income. Previous income is important for consumption because it helps in forecasting the future income of people.
Assumptions:
Given these. Friedman gives a series of assumptions concerning the relationships between permanent and transitory components of income and consumption.
1. There is no correlation between transitory income permanent income.
2. There is no correlation between permanent and transitory consumption.
3. There is no correlation between transitory consumption and transitory income.
4. Only differences in permanent income affect consumption systematically.
5. It is assumed that individual estimates of permanent income are based on backward looking of expectations.
Explanation of the Theory:
These assumptions give the explanation of the cross-section results of Friedman’s theory that the short-run consumption function is linear and non-proportional, i.e., APC> MPC and the long-run consumption function is linear and proportional, i.e., APC MPC.
Figure explains the permanent income hypothesis of Friedman where C is the long-run consumption function which represent the long-run proportional relationship between consumption and income of an individual where APC MPC. C, is the non-proportional short-run consumption function where measured income includes both the permanent and transitory components.
At OY income level where C, and C, curves coincide at point E. permanent income and measured income are identical and so are permanent and measured consumption as shown by At point E, the transitory factors are non existent. If the consumer’s income increases to OY, he will increase his consumption consistent with the rise in his income.
For this, he well move along the C, curve to E, where his measured income in the short-run is OY, and measured consumption is YE.. The reason for this movement from E to E, is that during the short-run the consumer does not expect the rise in income to be permanent, so APC falls as income increases.
But if the OY, income level becomes permanent, the consumer will also increase his consumption permanently. Now his short-run consumption
between measured and permanent income are due to the transitory component of income (Y)
Transitory income may rise or fall with windfall gains or losses and cyclical variations. If the transitory income is positive due to a windfall gain, the measured income will rise above the permanent income. If the transitory income is negative due to theft, the measured income falls below the permanent income. The transitory income can also be zero in which case measured income equals permanent income.
Permanent consumption is defined as “the value of the services that it is planned to consume during the period in question ” Measured consumption is also divided into permanent consumption (C) and transitory consumption (C) Measured consumption (or current consumption) may deviate from or equal permanent consumption depending on whether the transitory consumption is positive, negative or zero, Permanent consumption (C) is a multiple (k) of permanent income. Y and k-fir, w, u) Therefore, C-k (r, w, u) Y(3)
where k is a function of the rate of interest (r), the ratio of property and non property to total wealth or national wealth (iv) and the consumer’s propensity to consume (u). This equation tells that over the long period consumption increases in proportion to the change in Y This is attributable to a constant k (-CY) which independent of the size of income. Thus k is the permanent and average propensity to consume and APC-MPC
Friedman analyses the offsetting forces which lead to this result. To take the rate of interest (r), there has been a secular decline in it since the 1920s. This tends to raise the value of k. But there has been a long-run decline in the ratio of property and non-property income to national wealth (w) which tends to reduce the value of k. The propensity to consume has been influenced by three factors.
First, there has been a sharp decline in the farm population which has tended to increase consumption with urbanisation. This has led to increase of. Second, there has been a sharp des line in the size of families. It has led to increase in saving and reduction it consumption thereby reducing the value of k. Third, larger provision by the state for social security
This has reduced the need for keeping more in savings. It has increased the tendency to consume more resulting in the rise in the value of k. The function will shift upward from C, to C, and intersect the long-run consumption function C, at point E..
Thus the consumer will consume Y, E, at OY, income level. Since he knows that the increase in his income OY, is permanent, he will adjust his consumption Y E, accordingly on the long-run consumption function C, at E, where APC-MPC
It’s Criticism:
This theory has been criticized on the following counts:
1. Correlation between Temporary Income and Consumption: Friedman’s assumption that there is no correlation between transitory components of consumption and income is unrealistic. This assumption implies that with the increase or decrease in the measured income of the household, there is neither any increase nor decrease in his consumption, because he either saves or dissaves accordingly. But this is contrary to actual consumer behaviour.
A person who has a windfall gain does not deposit the entire amount in his bank account but enjoys the whole or part of it on his current consumption. Similarly, a person who has lost his purse would definitely cut or postpone his present consumption rather than rush to the bank to withdraw the same amount of money to meet his requirements.
2. APC of all Income Groups not Equal: Friedman’s hypotheses states that the APC of all families, whether rich or poor, is the same in the long-run. But this is against the ordinary observed behaviour of households. It is an established fact that low-income families do not have the capacities to save the same fraction of their incomes as the high income families.
This is not only due to their meagre incomes but their tendency to prefer present consumption to future consumption in order to meet their unfulfilled wants. Therefore, the consumption of low-income families is higher relative to their incomes while the saving of high-income families is higher relative to their incomes. Even in the case of persons at the same level of permanent income, the level of saving differs and so does consumption.
3. Use of Various terms Confusing: Friedman’s use of the terms “permanent”, “transitory”, and “measured” have tended to confuse the theory. The concept of measured income improperly mixes together permanent and transitory income on the one hand and permanent and transitory consumption on the other.
4. No Distinction between Human and Non-human Wealth: Another weakness of the permanent income hypothesis is that Friedman does not make any distinction between human and non-human wealth and includes income from both in a single term in the empirical analysis of this theory.
5. Expectations not Backward-Looking: Estimates of permanent income are based on forward looking expectations and not a backward-looking expectations. In fact, expectations are rational because changes in consumption are due to unanticipated changes in income that lead to changes in permanent income.
Conclusion: Despite these weaknesses, “it can be fairly said”. according to Micheal Evans, “that the evidence supports this theory and that Friedman’s formulation has reshaped and redirected much of the research on the consumption function.”
