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Life Cycle hypothesis is just permanent income with a different name.

Already Keynes said that the sole aim if the capitalist society is to consume. However not all our received or disposable income is devoted to consumption, some of it is saved. Keynes' idea was that people save because that yields them income and so they can consume more in the future. This idea was accepted by Friedman and Modigliani as one of motives to save and accumulate wealth in the long run. However they thought the main reason why people save is to spread out the major differences in income over the individuals life period, so it could spend continuously not only when it has income. Basically a consumer derives maximum utility from his income when he spends the permanent part of it only. If one would only spend then consumption and income will both look something like:

So even though some might hypothetically survive until the age of 10 when they could start earning income the mortality at 65 must be 1. So we must include the dissaving at very young and old age when income is low and saving at times when income is high. So we get a concept of accumulating and decreasing wealth - some of which is received as bequests and some of which is similarly given to offspring.

Friedman was first to come up with this idea. He called it the permanent lifetime hypothesis, assuming that the persons life is infinite, he will have an expectation of his average income and will consume accordingly and rest of it - the transitory income is being saved. So according to Friedman consumption will look like:

This has a number of implications. It is assumed that people will have a view of their permanent income based on the moving average of previous income and also of the income of the people similar to him. So when there is a one of rise in income of 1000 it will change the prediction off permanent income only a little and most of it is saved. Whereas when there is a permanent rise in the income of 1000 it will rise the permanent income hypotheses by 1000 and thus the savings ratio (deltaS/delta Y) will actually fall.

A concept of transitory income was also introduced by Friedman. It says that people will always have a deviation from the permanent income, called transitory income(TI). TI is different for different groups of people. People whose income fluctuates, e.g. farmers, have higher transitory income. As this TI is mainly saved then farmers consume relatively less.

A newer theory was made by Modigliani which criticised the Friedman's view in some occasions, but reached on broadly the same conclusions. First criticism was the infinite life-cycle one, because it allows nothing for bequests. But I think that the assumption that people will have an infinite life is reasonable, as people do not know when they die and usually want to leave as much wealth as they have left when they do die as bequest. And when you do know when you die you do not want (or possibly are not able) to spend that much more anyway! However Modigliani said that most of the people will retire at 65 and start working around 20 so they know that and can base their consumption accordingly. So the consumption will look more like:

It has similar implications. But the life cycle income is predicted by current income so less transitory income occurs. Difference also arises when the population and income are not static. When population rises, for example, then it would not make much difference in LCH, as young people will dissave relatively little. But in PIH it will make difference. There will be more young people. Savings will be higher and consumption lower. These effects are called Bentzel effects.

There is also an inequality issue accounted in LCH. It has been noted that top 20% give relatively much more of their wealth away as bequests and thus save more in order to do that. When income distribution gets more unequal there will be less consumption. This effect does not occur in PIH, because people do not care about their offspring and will adjust their permanent income when they get richer so to spend everything. However in long term these effects should cancel out. Kids of rich will have more wealth initially. So they do not have to save that much to accumulate extra wealth. They can safely earn income on their wealth. So the next generation, after the income inequality has risen, will consume relatively more, according to LCH.

So in general the direction of outcome is the same for both theories. But the derivation is different and the magnitudes of saving and consumption predicted by these models differ in the short run. So one is not precisely the other.


(simple sentences with 70% of the notes not used)

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