Relationship between Integration of PIH and LCH | Consumption Function

Learn about the Relationship between Integration of PIH and LCH.

In spite of difference in approach, focus and methodology the two hypotheses are closely related.

Families with high transitory income in Friedman’s analysis could be families in the middle year in the LCH and families with negative transitory income could be the ones at the end of the life cycle.

Thus the LCH 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 of expected future income relationship, i.e., consumption is a function of permanent income which is the present value of future income of an individual over his entire service life.

Integration of the Two Approaches:

Indeed modern theories of the consumption function combine the expectations formation emphasised by the permanent income approach with the emphasis on wealth and demographic variables suggested by the life cycle approach.

A simplified version of a modern consumption function would be:

C = aWR + bαY_i + b( 1 – α)Y_t-1 … (14)

where Y_t is disposable labour income. Equation (14) combines the main features that are emphasised by modern consumption theory presented by Hall and Taylor. It also shows the role of wealth, which has an important influence on consumption spending.

An equation like (14) performs quite well on an average in predicting consumption, because it embodies the estimate of permanent income implied by equation (14). If we have knowledge about some particular change in income — for example, that it is transitory — then we should use that knowledge in predicting consumption.

Kuznets hypothesised that consumption depends largely on current income. Keynes took a short term view of consumer behaviour. But post-Keynesians have focussed attention on intertemporal decision problems faced by consumers. Modigliani and Friedman, in particular, have reasoned that consumers look ahead to their future resources and needs.

As a result the consumption function hypothesis that they presented is much more complex than the one proposed by Keynes. While in Keynes’ absolute income hypothesis current consumption is a function of current income, recent work suggests that consumption is a function of current income, wealth, expected future income and interest rates. So current income is just one determinant of aggregate consumption.

Modern economists continue to debate on the relative importance of these determinants of consumption. In fact, the debate over the effects of government debt is partly a debate over the determinants of consumer spending. In this context mention may be made of Barro- Ricardo equivalence theorem.

The theorem simply suggests that it does not matter whether government spending is financed by debt or taxes. If government spending is financed by debt, households will choose to hold all of their increased debt without reducing the amount of saving that they devote to investment in new factories and machineries.

The reason that households would be willing to increase their saving in this way is that they anticipate that they will need to have extra wealth to pay increased taxes in the future. These households recognise that the government will eventually need to raise taxes in order to pay the principal and interest on its debt.