In this article, we will look into two important theories that talks about the nature of consumers and their spending patterns. How does spending depends on expected level of income ? Additionally, we will also see how the spending patterns affect the demand cycle of a country's economy. How the theory of permanent income opposes the idea of British economist John Maynard Keynes ? We will discuss about all these points in great detail in below section. So without further delay let's start !!
Understanding the theory of Permanent Income and Life Cycle Hypothesis
Both the theories of permanent income and life cycle are very important. Both discuss the nature of consumers and how different income patterns impact their spending. Consumer behaviour impacts the market and the overall economy as well. If consumers spend more it generates demand in the economy for goods and services which allows the economy to boost. Hence, both theories hold vital importance. We shall discuss both theories in complete depth, but the first question is what do these theories state and what is their relevance in terms of real life scenarios ?
Permanent Income Hypothesis
The theory of permanent income was introduced by a very famous economist Milton Friedman in the year 1957. The permanent income hypothesis focuses on consumer behaviour and how consumers spend under different circumstances. This theory mainly states that a consumer will spend their money at a level that is consistent with their income in the long run. The amount of average long-term income which is expected by the consumer, therefore, becomes the permanent income. In such cases, the consumers feel safer spending money as they expect a constant stream of money coming in every month.
Likewise, a consumer is more likely to spend less amount of money if they are insecure about their future income and fear that their current income may be more than what they might earn in the future.
The theory also implies that consumer behaviour is influenced by many different factors, and it is almost impossible to predict because every individual has different expectations. Hence, according to it even if the government makes policies to boost employment and increase income within the economy it doesn't need to have a multiplier impact on how the consumers spend. Instead, the consumer will only spend more and save less if they are certain about their future incomes. This theory opposes the idea of the Keynesian theory which stated that the spending of consumers is impacted by their current income after paying taxes.
Milton proposed that consumers like their consumption patterns are smooth and therefore they save for the future if they anticipate any decrease in their incomes to maintain their lifestyles in the future.
Another possible spending scenario can be that if the consumer is anticipating a bonus after a year, they may increase their current spending according to the bonus they might get in the future. Likewise, if consumer expects that there might be a windfall in the future, they may not increase their spending. Hence, we can say that predicting consumer behaviour is very difficult as it is not driven by a single factor. Every individual has different goals and ambitions hence all consumers spend on different items and behave completely differently from each other under different circumstances.
The example can also be of a consumer who is informed of receiving a certain amount of money in inheritance. Now, the consumer can increase his spending given the sudden increase in wealth. But according to this theory, the consumer will more likely maintain his current expenditures and will most likely try to invest the received funds to have a secure source of income for the future. People prefer to invest their assets for the long term to maintain their lifestyles after retirement than to spend their money immediately on materialistic things.
The liquidity of the person also plays a very important role in how their spending behaviour changes. A person with no assets may already be used to keep their spending high regardless of their future or current income. Other factors like expected salary raise, promotions and increments can also change the spending course of a person. Likewise, retirement, uncertainty about future income and expected losses in investments can cause a person to reduce their current spending and save for the future instead.
The theory of lifecycle hypothesis is also based on consumer spending behaviour, and it aims to explain how consumers spend and save money over their life spans. The theory states that consumers tend to borrow money when their incomes are low, and they save money when their incomes are supposedly high. This theory was introduced by economist Franco Modigliani and one of his students Richard Brumberg in the period of 1950s. It is proposed in this theory that individuals plan their spending and saving patterns over their lifetimes based on what they expect their future incomes to be.
Hence, when people are young and passionate, they tend to borrow more money as they expect that in the future, they will have the financial stability to pay off that debt, when they reach middle age, they start to save more to be able to maintain their current lifestyles when they get old and retire.
Assumptions of the Life-Cycle Hypothesis
The life-cycle theory has many assumptions. For example, the hypothesis states that people consume all their wealth when they reach old age. But in real life, most often the case is that people leave their wealth for future generations, or many old people do not spend a lot of money. People usually have the urge to save money and become wealthy, but most people cannot be able to save.
Another big assumption is that people tend to earn the most at a younger age instead of when they grow older. Although in real life some people lack the motivation to work extensive hours when they are young, and they tend to take on part-time jobs to provide for themselves when they get older. Younger people are also more inclined to make risky investments than older people.
The most important assumption of the theory is that people with higher incomes can save more, and they have more financial knowledge than people with low incomes who are more likely to be under heavy credit card debts. Other than that, government programs and retirement insurance plans also keep them from saving for their old age. As they are not worried about their expenses when they cannot work anymore due to old age.
Comparison of Life-Cycle Hypothesis with Keynesian Theory
The Keynesian theory was introduced by a very famous economist Jon Maynard Keynes in the year 1937. This was considered relevant before Milton introduced his theory. Keynes assumed that savings were also a good and people save more with time as incomes increase. The main problem with the hypothesis presented by Keynes was that it suggests that as the national income increases, it will also result in more savings. This would ultimately result in a decrease in the demand for goods and services and the total output of the economy would decline. Another big gap in the theory of Keynes was that he failed to explain consumer spending behaviour over time.
Criticism of the life-cycle approach
There are some major shortcomings in the theory of the life cycle such as the fact people spend their wealth when they reach their old age but that is not usually the case, people, when they reach old age, tend to spend less money on materialistic things and most of the time people prefer leaving their wealth for their future generations.
The theory also suggests that people are planners, and they tend to plan for their future, but in real life, most people lack the motivation to save, and they instead spend their incomes on materialistic things. People with high incomes have more knowledge about financial management than people with low incomes and rich people can also easily save a part of their incomes.
Life-Cycle Theory Vs Permanent Income Hypothesis
The theory of life-cycle theory pays more attention to the behaviour of individuals and their motives for saving. The permanent income hypothesis on the other hand discusses how people consume their income depending on their expectations regarding their future incomes. The other major difference between the two theories is that the permanent income hypothesis focuses on the permanent income source of the individual and the life cycle theory takes into consideration the income one earns throughout a lifetime.
In this article, we have seen the nature of consumer spending based on theories of Permanent Income and Life-Cycle hypothesis. We have also seen how the consumer spending under different circumstances affects a country's economy in the long term. We have talked about the assumptions and criticism of Life-Cycle theory and then finally we have seen the comparison between Life-Cycle theory and Permanent Income Hypothesis.