The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income (human capital, property, assets), rather than changes in temporary income (unexpected income), are what drive changes in consumption.
The formation of consumption patterns opposite to predictions was an outstanding problem faced by the Keynesian orthodoxy. Friedman's predictions of consumption smoothing, where people spread out transitory changes in income over time, departed from the traditional Keynesian emphasis on a higher marginal propensity to consume out of current income.
Income consists of a permanent (anticipated and planned) component and a transitory (unexpected and surprising) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not their current income. Unlike permanent income, transitory incomes are volatile.
Until A Theory of Consumption Function, the Keynesian absolute income hypothesis and interpretation of the consumption function were the most advanced and sophisticated. In its post-war synthesis, the Keynesian perspective was responsible for pioneering many innovations in recession management, economic history, and macroeconomics. Like the neoclassical school that preceded it, early inconsistencies had their roots in socio-political events contrary to the predictions put forward.
The introduction of the absolute income hypothesis is often attributed to John Maynard Keynes, a British economist, who wrote several books which are now the basis for Keynesian economics.
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The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948), who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.
The marginal propensity to save (MPS) is the fraction of an increase in income that is not spent and instead used for saving. It is the slope of the line plotting saving against income. For example, if a household earns one extra dollar, and the marginal propensity to save is 0.35, then of that dollar, the household will spend 65 cents and save 35 cents. Likewise, it is the fractional decrease in saving that results from a decrease in income.
In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers). The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.
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