The life-cycle hypothesis (LCH) & permanent y hypothesis (PIH)

These theories are alternatives to the Keynesian consumption function. The function assumes
that current consumption depends only on current yd. In the Keynesian formulation , a
temporary decline in Yd ( because of illness, unemployment or recession) must be met by a
similar temporary decline in consumption expenditures. Both theories refute this proposition.
Both the LCH and PIH acknowledge that consumption expenditure is the most important
determinant of NY, however, the difference here is the assumption that people hold an
estimation of their permanent level of Y in the s-r. Further current expenditures are based on
the estimation i.e Nat’L consumers plan their consumption over a longer time period than
current Y. Consequently a sudden increase in current Y is the S-R would not lead to an increase
in current consumption. Instead, the householder's spending pattern will remain the same
generally as this Y change will be regarded as temporary.
In these 2 models, consumption expenditure is divided into 2 component parts:

1) That portion that will vary within the level of Yd

2) The remaining portion which is regarded as autonomous

In the S-R , both consumption and saving will be subject to considerable fluctuations as Y
changes. However, in the L-R, there will be greater stability in both the APC and APS.

Life-Cycle Hypothesis (LCH)

This was developed by Franco Modigliani and was 1st published in 1954. The basic proposition
is that current Y is not only or primary determinant of current consumption expenditure,
expected future Y also influences current consumption.

The theory is thereforenon 2 fundamental assumptions:

1) People have some expectation about their life-time earnings

2) People maximize their utility by maintaining a steady level of consumption (for e.g. a
person who receives an increase in Y will not live more lavishly today, and starve when
Y decreases.

According to this theory both APC and APS will fluctuate in te S-R, but will tend to be relatively
stable in the L-R.
Permanent Income Hypothesis ( PIH)

In many ways, this theory is an extension of the LCH. It was developed by Milton Friedman and
aims specifically to address the issue of how expectations about future Y streams are formed.
Accordingly, the theory posits that current consumption expenditure relates more to what people
regard as their permanent Y stream than it does to current levels of y. People therefore form
expectations about L-R trends in future Y and then make consumption decisions based on
these expectations. So eg. if people find themselves low on Y, but only temporarily, they will
either reduce current saving or borrow in order to maintain consumption expenditure. On the
other end, if people find themselves on temporarily high Ys, they would save rather than
increase current consumption. Initially therefore, in the S-R, the ApC is expected to be high.
Young people examples will tend to have an APC in excess of 1; overtime as debts have been
paid off and as persons begin to save for old age and retirement the S-R APC will fall and S-R
ADS will rise.

Savings
Saving represents deferred consumption. By choosing to save, the saver simultaneously
chooses to lock away spending power for a period of time. In a closed economy with no
government sector , Y that is not consumed is saved ie Y=C+S.
Saving represents leakage from the circular flow of Y and much like investment, any Y
withdrawn from the circular flow in the form of saving will cause Nat’L Y to decrease by an
amount greater than the initial level of saving.
There are many motives for saving but the most common include:

1) Accumulating to acquire an asset that cannot be afforded presently

2) Putting aside for future consumption when future Y is expected to decline (deferred
consumption)
3) To earn interest and thus increase Y and saving

4) To guard against future uncertainties

There are many forms of saving and the method chosen by the saver depends on his/her
characteristics and wants. These forms of saving include :

1) Deposits with a financial institution

2) Purchase of financial assets (shares, stocks, bons, treasury bills and mutual funds)

3) Contributions to social insurance schemes

4) Premiums paid on assurance policies

In every economy, saving plays an important role in the general magnitude and trends of
economy activity, if we assume a closed economy with no gobernemt sector, a highly developed
culture of saving ie ( high MPS), the implication being a relatively low multiplier. In this type of
situation a high MPS would constrain the economy’s potential for economic growth.