Question

Difference between permanent and life cycle income theory of consumption and keynesian theory of consumption

Answer 1

Answer:

The two hypothesis of consumption theories – Life Cycle Income THeory (.L.C.T.) and Keynesian Theory  (P.I.H.) — 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.