Question

Compare and contrast the "life cycle" hypothesis and the "permanent income" hypothesis. What are their respective implications for inequality in the income distribution?

Answer 1

Before understanding the difference between life cycle hypothesis and permanent income, we have to understand life cycle and permanent income, which we can understand from the following point: -

The life-cycle hypothesis (LCH) is an economic theory that describes the spending and saving habits of people over the course of a lifetime. The concept was developed by Franco Modigliani and his student Richard Brumberg in the early 1950s. The theory is that individuals seek to smooth consumption throughout their lifetime by borrowing when their income is low and saving when their income is high.

The LCH assumes that individuals plan their spending over their lifetimes, taking into account their future income. Accordingly, they take on debt when they are young, assuming future income will enable them to pay it off. They then save during middle age in order to maintain their level of consumption when they retire. A graph of an individual's spending overtime thus shows a hump-shaped pattern in which wealth accumulation is low during youth and old age and high during middle age.

The permanent income hypothesis is a theory of consumer spending stating that people will spend money at a level consistent with their expected long-term average income. The level of expected long-term income then becomes thought of as the level of “permanent” income that can be safely spent. A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.

The permanent income hypothesis was formulated by the Nobel Prize-winning economist Milton Friedman in 1957. The hypothesis implies that changes in consumption behavior are not predictable because they are based on individual expectations. This has broad implications concerning economic policy.Under this theory, even if economic policies are successful in increasing income in the economy, the policies may not kick off a multiplier effect from increased consumer spending. Rather, the theory predicts there will not be an uptick in consumer spending until workers reform expectations about their future incomes.

It is clear from the above that what is the difference between the two, so we can conclude that if there is some similarity between the two, then there are some inequalities which we can see as follows: -

Would it be correct to say that the Permanent Income Hypothesis (PIH) stipulates that current consumption decisions are made based on future income projections/expectations, while the Life Cycle Hypothesis (LCH) claims that consumption is constant over the average person's life time, and this is made possible, despite changes in income level throughout his/her lifetime, through borrowing when younger and savings during the elderly years?

: The aim of this contribution is to discuss closely the implications of
income inequality and the economic policies to tackle it, especially so in view of
inequality being one of the main causes of the 2007/2008 international financial
crisis and the “great recession” that subsequently emerged. Wealth inequality
is also important in this respect, but the focus is on income inequality. Ever
since the financial crisis and the subsequent “great recession”, inequality of
income, and wealth, has increased and the demand for economic policy initia-
tives to produce a more equal distribution of income and wealth has become
more urgent. Such reduction would help to increase the level of economic
activity as has been demonstrated again more recently. A number of economic
policy initiatives for this purpose will be the focus of this contribution.