Let us make in-depth study of the life cycle, permanent consumption and implications of Post-Keynesian theories of consumption.
Life-Cycle Theory of Consumption:
In Keynes’s theory of consumption function, consumption expenditure in a period depends mainly on current income.
After Keynes some economists such as Franco Modigliani and Milton Friedman pointed out that individuals while making their consumption decisions take into account not only the current income which was emphasised by Keynes but also the income they expect to receive in the future.
Therefore, the consumption theories of Franco Modigliani and Milton Friedman, both are Nobel Laureates, have been called Future-Oriented Consumption Theories by Joseph Stiglitz. Consumption theory put forward by Modigliani is called Life-Cycle Theory of Consumption as he emphasises that in deciding about consumption out of income in the working years of their life they attempt to save for the post-retirement period. Their motive for doing so is to smoothen or even their consumption in their entire life span. That is, they save from the income of working period of their life so that they will not have to cut down consumption level after they retire.
The life-cycle theory assumes that an individual in early years of life earns no income and is maintained by his parents or other relatives. In the middle period of his life he works and earns income. Though in the middle period of his life he spends a good deal on consumption of his own and his family members, on balance he earns more than he consumes and therefore saves a part of his income. His motive of saving is to accumulate assets or wealth, which yields him enough income so as to maintain satisfactory standard of consumption in later years of his life after he retires.
Thus in the final stage of his life cycle when the individual has retired from work his earnings from work is very little or nil while he spends a good deal on his consumption; it is income from his past savings or accumulated assets that enables him to maintain satisfactory standard of consumption over his whole life cycle.
Permanent Consumption Theory:
Like Modigliani, Milton Friedman also thinks that expectations about future income affect current consumption in a period. He points out that people save in good years so that they have not to curtail consumption in bad years. In other words, in Friedman’s view, consumption of individuals or households depends on permanent income in contrast to current income level as emphasised by Keynes. By Permanent income he means average long-run income.
Therefore, Friedman’s theory is known as permanent Consumption Hypothesis. According to this view, temporary changes in income such as bonus received in a year, or large capital gains received due to rise in prices of shares or real estate do not have much effect on consumption as the permanent changes in income, that is, changes in long-run average income.
According to Friedman, temporary or transitory changes in income will have little effect on consumption while permanent changes in income will have large effect on consumption. Thus, according to Friedman’s permanent consumption theory, if households could predict their future income level, they will adjust their consumption levels according to their permanent average long-run income.
Thus, according to Friedman, income of an individual consists of permanent income and transitory income.
Y = Yp + Yt
C = Cp + Ct
where Y stands for income, Yt for transitory income, C for consumption, Cp for permanent consumption and Ct for transitory consumption. It is worth emphasizing that, according to Friedman, permanent income should be viewed as earnings both by human and non-human capital of the individual. By income from human capital he means earnings made from labour and by income from non-human capital is the earnings from physical assets held by him.
Thus, Friedman is of the view that both income and consumption of an individual should be divided into two parts—permanent and transitory. Permanent income is the part of income that an individual expects to go on receiving overtime in future. On the other hand, transitory income occurs accidently or by chance. These transitory incomes may occur due to bad purchases of commodities or assets which yield him losses which therefore represents negative income or they be the result of favourable chance purchases (for example, purchases of certain shares or winning of lotteries) which therefore yield positive income.
Corresponding to the concept of permanent income there is a notion of permanent consumption. Permanent consumption is the consumption expenditure which an individual expects he will be making over long time in future. The crucial point which Friedman makes is that permanent consumption of individuals depend on permanent income rather than current income as believed by J.M. Keynes.
Besides, according to Friedman, permanent income is very much a reflection of the capital value or wealth and this wealth consists of capital value of principal assets possessed by an individual and his human capital (i.e. his earning ability depending on the knowledge and skills possessed). According to Friedman, consumption is proportional to permanent income Thus,
C = k Yp
where k represents the proportion of permanent income that is consumed in the current period. This proportion depends on rate of interest (i), desire to accumulate wealth (w) and individual desire for immediate or current consumption. Friedman’s consumption theory is summed up in the following equation.
CP = k (i, w, u)YP
where k is the proportion of permanent income (YP) that is spent on permanent consumption. This proportion depends on rate of interest (i), the ratio of non-human (i.e. physical) wealth to income (w) and the preference of individuals for in mediate or current consumption as against his willingness to accumulate assets or wealth (u). According to Friedman, higher rate of interest would induce people to save more and thus reduce his consumption expenditure. Besides, proportion of individual’s consumption to their permanent income depends to a great deal on the assets or wealth of an individual, that is, w in the above function.
The greater the wealth or assets of an individual, the higher his consumption expenditure. Lastly, the proportion (k) of consumption expenditure to permanent income depends on individual’s desire for immediate or current consumption as against his willingness to add to his wealth or assets.
Milton Friedman emphasises that consumption of individuals is affected by changes in individuals’ wealth which is a stock variable in contrast to the current income which is a flow variable. Friedman’s permanent consumption theory suggests that individuals’ consumption depends on how well-off they are and that is better measured by their wealth. Individuals’ wealth changes when the value of their assets such as prices of stock shares and real estate change. When their prices rise, people enjoy capital gains which make them wealthier and as a result their consumption out of a given income rises.
With this the consumption functions curve shifts above. Commenting on the future-oriented theories of consumption and saving of Modigliani and Friedman, Joseph Stiglitz writes, “Both Modigliani and Friedman stressed that individuals generally try to stabilize their consumption using savings to smooth consumption so that it does not fluctuate dramatically from year to year. They also stressed that individuals will be forward-looking, basing current consumption decisions on their expectations about future income”.
There are three important implications of the above two future-oriented theories of consumption and saving. First, important implication is that changes in expectations about future income affect the current consumption of individuals even though their current income has not changed.
Consider the case when an economy is currently experiencing recession, as has been the case in 2008- 09 afflicted by global financial crisis and global meltdown, people became quite pessimistic about their future income prospects which led them to curtail consumption and save more even though their current income did not change. This causes the consumption function curve to shift downward.
Another implication is that one-time or temporary changes in income will cause only a small change in consumption. Suppose a person has a windfall gain of Rs. 10 lakhs in a year due to his winning a lottery. Given his marginal propensity to consume equal to 0.8, the Keynesian consumption function predicts that his consumption will increase by Rs. 8 lakhs and the remaining Rs. 2 lakhs will be saved by him in that year.
On the other hand, the future-oriented theories of Modigliani and Friedman predict that the consumption of extra income gained by the lottery winner during a year will be spread over his lifetime or over a long period of time.
Similarly, a more important case from the viewpoint of economic policy is the temporary reduction in the direct tax at the time of recession by the government to boost consumption demand as had been done by the US government in 2007-08 and 2008-09 to fight recession.
The above two future-oriented theories predict that contrary to the prediction of the Keynesian model the temporary reduction in direct taxes will be much less effective in boosting consumption demand as due to uncertain economic prospects much of the income gained through temporary tax reduction will be saved. The evidence from the US shows this has in fact been the case.
The third related implication of the future-oriented theories is that since changes in income that individuals expect to be only temporary will have only small effect on consumption spending, marginal propensity to consume will be lower and the multiplier effect of such changes in income (such as increase in disposable income brought about by reduction in taxes) will be smaller.
To conclude, leaving aside the cases of temporary changes in income and the concern of the forward-looking people to ensure same consumption standard in the future, the Keynesian theory of consumption is right in visualizing that individuals’ consumption spending is more dependent on current income.
To quote Stiglitz, “The permanent income and life-cycle saving hypotheses contain large elements of truth. Families do save .or their retirement and they do smooth their consumption between good years and bad. Even so, households spending appear to be more depended on current income than either future-oriented theory would suggest”