Question

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

Answer 1

DIFFERENCE BETWEEN PERMANENT AND TRANSITORY INCOME

The average of all the resources of a household is termed as permanent income,it is a long term concept.Permanent income comprises of the current income of a household as well as the changes that may occur in the current income like getting a promotion which ,might increase the income or getting fired from a job which may reduce our income.In order to sum up permanent income the current incomes are added with the future change in income are averaged to find out the amount the household should consume in the long run average.

Transitory income on the other hand is not a fixed source of income.It is temporary in nature and it is usually not expected.When a person wins a lottery or a lucky draw it is considered as transitory income ,as not everyone participating in the lottery or lucky draw expect to win and even if they win the probability of them winning again is very low.

According to Friedman,households should consume the permanent income.and they must save the transitory income.So consumption was a function of permanent income where as saving was a function of transitory income.So,according to him permanent income was more important than transitory income for consumption.