Macroeconomics

Income, Consumption, and Household Behavior

Permanent Income Hypothesis The Origin

Sheng Guo
Department of Economics
Florida International University

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Origin

Consumption function: to study the relation between consumption and

income.

J.M. Keynes the Absolute Income Hypothesis

1 current c is a highly dependable and stable function of current y;

2 due to fundamental psychological rule, when y , c/y , s/y ;

Empirical analysis:
1 estimate MPC, ,
from ci = + yi + i ;

2 compute APC = yc ;

3 documented findings: MPC < 1; MPC < APC.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Origin

Later contradictions:
1 Kuznets found no rise in s/y during 1900-1950s, despite y .

2 APC roughly the same, but MPC differs from different cross-section
household studies.

3 Post-WWII, s/y much lower.

4 Inequality of income , even though MPC < 1 implies the rich getting richer,
the poor getting poorer.

Milton Friedmans Permanent Income Hypothesis as the answer to

interpret the empirical evidence, challenging Keynes AIH.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Friedman derived his version of PIH from the canonical two-period

intertemporal choice model with no uncertainty and no
borrowing/lending constraints.

PIH is much more general than Friedmans formulation, although he

originated it.

A more modern version of PIH can be derived from a general

intertemporal choice framework with specific, (somewhat) restrictive
assumptions.

Despite this, the testable implications from PIH are profound and
stimulated hundreds of papers.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

A single equation emerges after the derivation:

cp = k (r, , u)yp

where r interest rate; ratio of non-human wealth to PI; u

preference factors.

We will derive much more complex versions of PIH, but Friedmans

genius is in how to put this single equation into work.

He distinguished between expected and actual measures (or ex ante

v.s. ex post).

Even after all feasible adjustments, one still cannot obtain a perfect
measure corresponding to theoretical concepts.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Let yi person is measured income; yip person is permanent

income; yit person is transitory income

yi = yip + yit (1)

This construction has the flavor of error-riden variable in econometrics.

yip depends on the persons characteristics, such as education,

occupation, personality, family background, etc.

yit includes all other effects that makes yi deviate from yip : accidental
effects, cyclical fluctuations, measurement error, etc.

It was acknowledged that yit does not disentangle idiosyncratic

components and systematic components.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Friedman warned against interpreting yip as the weighted average of

life-time earnings, for one life-path is but one realization of a stochastic
process (Figure 2, next slide).

He also conceptually distinguished cross-section average vs. time-series

average.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Figure 2 from Friedman (1957)

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Similarly for consumption

ci = cip + cit (2)

Forces that affect cit may include promotional coupons, computer

crashes, sickness, etc.

We already saw the relation b/w cip and yip

cip = k (r, , u)yip (3)

Next, we impose restrictions on definitional equations (1), (2), and (3).

The purpose is to derive implications from the model so that it can be

possibly contradicted by data.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Restriction One:

Cov(yip , yit ) = Cov(cip , cit ) = Cov(yit , cit ) = 0 (4)

Note that Cov(yit , yi ) = Cov(yit , yip + yit ) > 0

If looking at a sample of individual units with measured income y0 , we

have
Cov(yip , yit yip + yit = y0 ) < 0 .

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Examples to think about Cov(yit , cit ) = 0

1 Lottery windfall;

2 Inheritance (anticipated / unanticipated);

3 Overtime work;

4 Measurement error in y and c.

Friedman agreed that (4) may not be absolutely correct, but it may be a
close approximation of reality and is helpful for generating refutable
predictions.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Restriction Two:
y t = E(yit ) = c t = E(cit ) = 0 (5)
Assume k () is identical among the individual observations (individual
homogeneity assumption), then

cip = kyip c p = k y p c = k y

because of (5).
Therefore we can compute that

k = c/y (6)

Now lets see the interpretation for MPC.

Examine the linear regression of ci on yi

ci = + yi + i (7)

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

p p
Cov(ci , yi ) Cov(ci + ci , yi + yi )
t t
= =
Var(yi ) Var(yi )
Cov(cip , yip ) + Cov(cip , yit ) + Cov(cit , yip ) + Cov(cit , yit )
=
Var(yi )
Cov(cip , yip ) Cov(kyip , yip )
= =
Var(yi ) Var(yi )
k Var(yip )
= k Py
Var(yi )

Py measures the proportion of variation in income that can be attributed

to PI.
(MPC) is the product of k (Consumption Propensity of PI) and Py .
When Py = 1, = k ; when Py = 0, = 0.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Friedmans PIH

Recall that c
y
= k . We can show < k graphically (The famous graph).

d c/c
The elasticity of consumption to income cy = d y/y

Measured at the point of sample mean:

dc y
cy =
dy c
y y 1
= = kPy = kPy = Py
c c k

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Consistency of PIH with evidence

Income inequality is not increasing, despite the evidence that savings

seem to be a successively larger fraction of income. This is because c in
low y years may be financed by positive savings of high y years.

APC 0.90, for different periods and countries; MPC 0.67 0.79
(differ mainly between farm and non-farm units) (Table 1).

Farm vs. non-farm consumer units: APC (k ) lower, (Py ) lower

MPC (k ) lower (Table 3).

From (Py ) and variance (std. dev.) of yi , we can back out the variance
(std. dev.) of yip and yit (Table 4).

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Table 1 from Friedman(1957)

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Table 3 from Friedman(1957)

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Table 4 from Friedman(1957)

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Tests Using Modern Data: Fifty Years Later

DeJuan and Seater (2006) is a test of the original Friedman model using
modern data (Consumer Expenditure Survey).

c
One assumption they make is k = y
= 1 (see previous evidence from
Friedman (1957)).

Therefore from the regression of log of consumption on log of income we

get the slope as (slope is the same everywhere including the mean point)
ln c c/c c/y c
= = = cy = = k Py = Py . (8)
ln y (c,y) y/y c/y y

This is the result solely derived from the relationship between measured
consumption and income.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Tests Using Modern Data: Fifty Years Later

Next, consider some assumptions about the time-series properties of

income (also originated from Friedman (1957)).

For example, consider the mean assumption of the growth of income for
a group of households (1, 2 index adjacent periods):

yi2p yi1p y 2 y 1
=
yi2p y2

which implies
y1
yi1p = yi2p , . (9)
y2

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Tests Using Modern Data: Fifty Years Later

Therefore from the regression of log of lagged income on log of current

income we get the slope as (slope is the same everywhere including the
mean point)
ln y1 y1 /y2 Cov(yi1 , yi2 )/Var(yi2 )
= = y1 y2 = p p
ln y2 y 1 ,y 2 y 1 /y 2 y 1 /y 2
Cov(yi1p + yi1t , yi2p + yi2t )/Var(yi2 ) (10)
=

Var(yi2p )/Var(yi2 )
= = Py .

From (8), essentially we want to prove cy = y1 y2 .

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Tests Using Modern Data: Fifty Years Later

But cy = y1 y2 is not a statistical statement. For each sample, this cannot

exactly hold.

So instead, we form a statistical statement of the equality

cy,g = 0 + 1 y1 y2 ,g + g , (11)

for which the null hypothesis is 1 = 1. (g indexes groups; each group

produces a sample estimate of cy,g and y1 y2 ,g .)

There are different ways of classify observations into groupsregion,

occupation, education, and their interactions, etc.

Sheng Guo, FIU Econ Eco7207 PIH: The Origin

Tests Using Modern Data: Fifty Years Later
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