Question

If the permanent income hypothesis is correct, we should expect to see a lower marginal propensity to consume in the short run than in the long run. Why?

Short answer

MPC is lower short term due to temporary income perceptions; it increases long term as income changes are seen as permanent.

Step-by-step solution

Understanding the Concept

The Permanent Income Hypothesis (PIH), proposed by Milton Friedman, suggests that individuals base their consumption on their "permanent income" rather than their current income. This means that people smooth out their consumption over time, adjusting only partially to temporary changes in their income.

Dissecting Marginal Propensity to Consume

Marginal Propensity to Consume (MPC) refers to the fraction of additional income that is spent on consumption rather than saved. In the short run, when income changes are perceived as temporary, individuals are likely to save more of this additional income to buffer against future income fluctuations, resulting in a lower MPC.

Comparing Short Run and Long Run

In the long run, individuals perceive changes in income as permanent and therefore adjust their consumption upwards to match what they consider their permanent income level. This results in a higher MPC because individuals feel more confident in increasing their consumption when they expect their income to remain stable.

Conclusion

In summary, the Permanent Income Hypothesis leads to the expectation of a lower MPC in the short run compared to the long run because temporary income changes influence short-term saving behavior, while long-term income changes are integrated into consumption habits.

Key concepts

Marginal Propensity to Consume

The Marginal Propensity to Consume (MPC) is a key concept in understanding consumer behavior. It tells us how much of an additional dollar earned is spent on consumption.
The MPC varies depending on whether individuals regard income changes as temporary or permanent.
Milton Friedman's Permanent Income Hypothesis suggests that people consider only part of their income as temporary and another part as permanent. When people sense a temporary rise in their income, they tend to save more. This behavior results in a lower MPC because consumers want to protect themselves against future uncertainties.
They do not change their consumption habits dramatically as they consider the additional income a short-term adjustment. However, if individuals perceive the income increase as a permanent change, they tend to consume more of that income. Their confidence in the stability of future income allows them to integrate these changes into their regular consumption patterns. Thus, the MPC is higher when income is seen as permanent.

short run versus long run

Understanding the difference between the short run and the long run is crucial in economics. It's all about time and how individuals adjust their behavior over different periods. **In the Short Run** - Consumers tend to react cautiously. - Any income changes are often seen as temporary. - People might save more to prepare for their expected return to usual income levels.
Consequently, the MPC tends to be lower because spending doesn't increase significantly. **In the Long Run** - Changes become seen as permanent. - People feel more secure in their economic situation.
This security leads them to adjust their spending habits accordingly. - As consumption habits adjust to what they perceive as "permanent income," the MPC tends to increase. This contrast reflects a gradual shift from saving part of an increased income to feeling comfortable in spending more of it, as initially transient changes settle into perceived permanence.

consumption smoothing

Consumption smoothing is a fascinating concept within the Permanent Income Hypothesis framework. It describes how individuals allocate their spending and saving to keep their consumption level stable over time. People prefer not to experience sharp ups and downs in their standard of living.
That's why instead of letting their spending fluctuate wildly, they smooth out their consumption by saving during good times and dipping into savings during less prosperous periods. **Benefits of Consumption Smoothing** - Provides a stable lifestyle, reducing economic stress. - Helps in planning long-term expenditures like education or a home purchase. - Avoids sudden decreases in living standards, which can be tough to adapt to. This behavior aligns with the concept of permanent income because individuals expect their income to be relatively even over a long period. Therefore, they don't let short-term fluctuations in income drastically change their consumption patterns. By smoothing consumption, individuals balance their income across high- and low-income periods, achieving a steady lifestyle and enhancing their overall well-being.