Question

3) Explain the difference between permanent and transitory income. Which of the two is important for consumption in the Friedman theory? (7 points)

Answer 1

Permanent Income - Permanent income is the return on the house hold's human and non - human wealth. Permanent income is the steady rate of expenditure a person could maintain for the rest of his or her life, given the present level of wealth and the income earned now and in the future Transitory Income - transitory income refers to unexpected or temporary income Winning a lottery can be considered as an example of transitory income According to Friedman transitory income should be saved According to the permanent income hypothesis of Milton Friedman, permanent income is important for consumption. Because, permanent income hypothesis argues that consumption is related not to current income but to a long term estimate of income that is permanent income. Because consumers prefer a smooth consumption flow rather than plenty today and scarcity tomorrow In a simplest form, Friedman's theory argues that consumption is proportional to permanent income C = cYP, where YP denotes permanent (disposable) income (Reference: Macroeconomics by