The Absolute , Relative and Permanent Income Hypothesis
In macroeconomics, the Absolute Income Hypothesis, Relative Income Hypothesis, and Permanent Income Hypothesis provide different perspectives on how income influences consumption behavior, which in turn affects aggregate demand, savings, and overall economic stability. Here is a detailed look at each hypothesis in the context of macroeconomics.
Let’s compare the assumptions and key points of the Absolute Income Hypothesis, Relative Income Hypothesis, and Permanent Income Hypothesis.
Absolute Income Hypothesis (AIH)
Proposed by: John Maynard Keynes
Key Assumptions:
1. Current Income as Primary Determinant:
Consumption depends directly on current income.
2. Linear Consumption Function:
- Consumption function:
- C0m: Autonomous consumption
- cm: Marginal propensity to consume (MPC), with 0 < c < 1.
3. Short-Term Focus:
Focuses on the short-term relationship between income and consumption.
4. Stable Relationship:
The consumption function is stable over time.
5. Savings as Residual:
Savings are what’s left after consumption.
6. Homogeneity of Consumption Patterns:
Similar consumption patterns across different income levels, though proportions may vary.
Macroeconomic Implications
1. Multiplier Effect
The AIH is central to the Keynesian multiplier effect, where changes in aggregate income lead to amplified changes in aggregate consumption and thus economic output.
2. Fiscal Policy
Government policies that affect income (e.g., tax cuts, direct transfers) can directly influence consumption levels and thereby impact overall economic activity.
3. Short-Term Economic Fluctuations
The AIH helps explain how short-term changes in income, such as those caused by economic cycles, affect consumption patterns and aggregate demand.
Relative Income Hypothesis (RIH)
Proposed by: James Duesenberry
Key Assumptions:
1. Relative Income Effect:
Consumption is influenced by an individual’s income relative to others in their reference group.
2. Demonstration Effect:
Individuals emulate the consumption patterns of those with higher incomes.
3. Habit Persistence:
Past consumption levels influence current consumption; difficult to reduce consumption once a certain standard of living is achieved.
4. Asymmetric Response:
Different responses to income increases and decreases; consumption habits adjust slowly downward.
5. Relative Deprivation:
People feel deprived if their consumption is lower than their peers’.
6. Social Comparisons:
Continuous comparison with others influences consumption choices.
7. Impact on Savings:
Savings rates are influenced by relative income; lower relative income may lead to lower savings or increased debt.
8. Aggregate Consumption Stability:
Aggregate consumption is more stable than individual consumption due to relative income effects.
Macroeconomic Implications:
1. Consumption Patterns
RIH suggests that consumption patterns are heavily influenced by social norms and relative income, which can lead to higher levels of consumption inequality.
2. Inequality and Aggregate Demand
Changes in income distribution can have significant effects on aggregate consumption and demand. Higher inequality may lead to lower aggregate consumption if lower-income households increase their savings rates to keep up with consumption norms.
3. Stability of Consumption
Aggregate consumption may be more stable than predicted by the AIH, as individuals maintain consumption levels based on social norms and habits even during income fluctuations.
Permanent Income Hypothesis (PIH)
Proposed by: Milton Friedman
Key Assumptions:
1. Distinction Between Permanent and Transitory Income:
-
- Permanent Income: Long-term average income.
- Transitory Income: Short-term income fluctuations.
2. Consumption Smoothing:
Individuals aim to maintain a stable consumption pattern over time, based on permanent income.
3. Rational Expectations:
People use all available information to form expectations about their future income.
4. Marginal Propensity to Consume (MPC):
High MPC out of permanent income, low MPC out of transitory income.
5. Intertemporal Optimization:
Consumption choices are made to maximize lifetime utility, spreading consumption over time.
6. Access to Credit Markets:
Assumes individuals can borrow and save freely to smooth consumption.
7. Wealth Consideration:
Permanent income includes returns on wealth.
8. Lifecycle Considerations:
Consumption decisions account for the entire lifecycle, saving during high-income periods and dissaving during low-income periods.
Macroeconomic Implications:
1. Long-Term Consumption Patterns
PIH suggests that consumption is based on long-term income expectations rather than current income, leading to more stable consumption patterns over time.
2. Policy Effectiveness
Temporary fiscal policies (like short-term tax cuts or stimulus checks) might have limited impact on consumption because individuals base their spending on permanent income.
3. Credit Markets
The ability of individuals to borrow and save to smooth consumption highlights the importance of well-functioning credit markets for economic stability.
Comparison Summary
Key points of Difference between Absolute, Relative and Permanent Income Hypothesis
| Aspect | Absolute Income Hypothesis | Relative Income Hypothesis | Permanent Income Hypothesis |
| Proposed by | John Maynard Keynes | James Duesenberry | Milton Friedman |
| Primary determinants of consumption | Current income | Relative income (social comparisons) | Permanent income (long-term average income) |
| Consumption function | C= C0 + cY | Depends on social comparisons and past consumption. | Based on permanent income, smoothing over time. |
| Key assumptions | · Current income directly affects consumption
· Stable relationship · Short-term focus |
· Consumption influenced by income relative to others
· Demonstration effect · Habit persistence |
· Distinction between permanent and transitory income
· Rational expectations · Consumption smoothing over time |
| Response to income changes | Immediate and proportional to current income. | Influenced by social norms, less responsive to decreases. | Based on permanent income, stable despite temporary changes. |
| Policy implications | · Fiscal policy impacts are immediate
· Useful for short-term analysis |
· Importance of income distribution
· Policies to reduce inequality can influence consumption |
· Temporary policies have limited impact
· Long-term planning and lifecycle considerations are key |
| Stability of consumption | Varies with current income | Relatively stable due to social comparisons and habits | Stable due to consumption smoothing |
In macroeconomics, these hypotheses provide different lenses through which to analyze consumption behavior, aggregate demand, savings, and the effectiveness of economic policies. Understanding these hypotheses helps policymakers design interventions that can effectively influence economic outcomes based on the nature of income changes and consumer behavior.
