Comparison of PIH with LCH of Hypothesis | Consumption Function

Learn about the Comparison of PIH with LCH of Hypothesis.

The two hypotheses – LCH and PIH — are not mutually exclusive.

The LCH pays more attention to the motives for saving than the PIH does and argues strongly in favour of including wealth as well as income in the consumption function. The PIH, on the other hand, pays more attention to the way in which individuals form expectations about their future incomes than the LCH does.

In truth, current labour income enters the life cycle consumption function to reflect expectations of future income. At the same time, the more detailed analysis of the determinants of expected future income that is provided by the PIH can be, and has been, included in the life cycle consumption function.

Friedman’s approach differs from Modigliani’s approach mainly in the treatment of the present value of future income, especially in how they relate this term to observable economic variables for the empirical testing of their hypotheses. Friedman’s model is somewhat less satisfactory than the Ando-Modigliani model in that assets are only implicitly taken into account as a determinant of permanent income.

In addition, it relies on the observable aspects of income — ‘permanent income’ and ‘transitory income’ — that the Ando-Modigliani model, which separates out the observable components — labour income and value of assets.

Moreover Friedman’s model explains both the cross-sectional budget studies and short- run cyclical observations that indicate MPC < APC and the long-run observation that the C/Y ratio is fairly constant, that is, APC = MPC.

His model is somewhat less satisfactory than the Ando-Modigliani model in that assets are only implicitly taken into account as a determinant of permanent income and it relies on less observable aspects of income — “permanent” income and “transitory” income. But the Ando-Modigliani model separates out the observable components into labour income and value of assets.

In the final diagnosis, it appears that the two models are closely related. Families with high transitory income in Friedman’s analysis could be families in the middle years in the Ando-Modigliani life cycle, and families with negative transitory income could be the ones at the ends of the life cycle. Thus, the life-cycle hypothesis could be one explanation of the distribution of Friedman’s transitory incomes.

The two hypotheses are similar in the starting point of the analysis in the consumption- present-value relationship as given by equation (13).

0 = fⁱ(PVⁱ), …(13)

They are also similar in explaining cross-sectional results.

The Ando-Modigliani model might be more useful to econometric model builders and forecasters since it explicitly includes measured current income and assets to explain consumption, but it may also need careful interpretation in cases where income changes are clearly transitory in nature, and permanent income considerations seem to be of much greater relevance.