An Introduction to Income Hypothesis

Income Hypothesis is mainly about observing consumers’ behavior proportional to their income. This can be divided into three main categories.

• Permanent Income Hypothesis (PIH)

This was formulated by the economist Milton Friedman and it explains that changes in consumption behaviors are not predictable, as they are based on long-term income expectations of customers. The key conclusion is short-term changes in income have a very little effect on consumer spending behavior. In permanent income hypothesis model, an individual’s real wealth but not his current real disposable income is the key determinant of consumption and it’s determined by one’s both tangible and intangible assets. Such as properties, shares, education etc. The main idea of permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. An increment in income should not increase consumption immediately by spending very much, but with time it should be affected.

C[i] = k[i] * Qp[i][t-1] + k[i] * g[i] *(Q[i] – Qp[i][t-1])
C[i] = consumption spending of an individual
k[i] = the proportion of the permanent income that is spent on consumption
Qp[i] = the permanent income / expected income, measured over a longer period of several years.

The equation can be extended with includes of how the expectations about future income resources can be formed, for instance with adaptive expectations: Qp[i][t] = Qp[i][t-1] + g[i] * (Q[i] – Qp[i][t-1]).
Q[i] = the actual income. If the actual income is above the expected permanent income, the expectations will be adjusted by a fraction g[i] of the difference between the expected (permanent) income and the actual income.

• Absolute Income Hypothesis (AIH)

This theory by Keynes based on the fact that the consumption level of a household depends on its not relative but absolute level hence the current level of income and also explains as income rises, the consumption will also rise but not necessarily at the same rate.
C = ^(W Y), additional variable W represents the state of the news, a term that changes with long-term expectation.
Consumption became a function, relating aggregate consumption,
C = mainly to aggregate disposable income
Y = income less taxes and transfer payments.

• Relative Income Hypothesis (RIH)

James Duesenberry’s, relative income hypothesis refers to an individual’s attitude to consumption and saving reflects more by his income in relation to others than by abstract standard of living. The aggregate ratio of consumption to income is assumed to depend on the level of present income relative to past peak income. Relative income hypothesis is the most realistic and successful theory when it comes to income hypothesis formulas. It shows how the consumption of a consumer reacts to the change of his/her income in a more acceptable way.

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