This paper compares Keynesian consumption theory and the more modern permanent income hypothesis by presenting the implications of the assumption that consumers are not myopic.
Written in 2009; 1,105 words; 4 sources; MLA; $ 38.95
Paper Summary:
In this article, the writer studies J. M. Keynes' consumption theory, also known as the absolute income hypothesis, and the permanent income hypothesis, suggested by M. Friedman in the famous paper "A Theory of the Consumption Function". The writer starts with a brief overview of the Keynesian consumption theory and then continues with the explanation of the permanent income hypothesis (PIH). The writer maintains that the Keynesian consumption theory fails to provide a valid explanation of consumer behaviour in the sense that it does not incorporate rational expectations that sensible and generally forward-looking consumers make. The writer concludes that Friedman's permanent income hypothesis, therefore, becomes more plausible when it suggests that consumption tends to be smoothed out throughout time periods allowing for income fluctuations to occur and that consumption responds to permanent changes in permanent income rather than to temporary changes in actual income.
From the Paper:
"Clearly, the main weakness of the Keynes' theory is that it assumes that individuals are short-sighted because they observe their actual income only and ignore the potential future income (or lack of it). A more reasonable approach is to presume that consumers' behaviour is likely to be intelligent and forward-looking. In this case, current consumption decisions become highly dependent on the expectations about the future, i.e. future labour income, real interest rates or taxes. The model which incorporates these expectations is the permanent income hypothesis.
"The central idea behind the PIH model is that individuals form estimates of their ability to consume in the long run and then set current consumption to the appropriate fraction of that estimate in order to smooth out their consumption over periods even when their income may be subject to fluctuations."
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