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The permanent income hypothesis

from Lars Syll

FRIEDMAN FRIDAY Milton Friedman's “Free to Choose” film transcripts and  videos here on www.thedailyhatch.org | The Daily HatchAlmost all mainstream macroeconomic theories are based on Milton Friedman’s permanent income hypothesis (PIH). It is mostly used in formulating the consumption Euler equations that make up a vital part of ‘modern’ New Classical and ‘New Keynesian’ macro models.

So, what’s the problem with PIH? Well, only that empirical evidence have — again and again — falsified it!

One implication of PIH is that current consumption is modelled as not being influenced by predictable changes in incomes changes. Heaps of empirical consumption studies — going back for decades — however show that this is not the case.

Given this, it is rather disappointing to see how this falsified hypothesis is treated in mainstream economics.

Let me give just one example.

Wendy Carlin’s and David Soskice’s macroeonomics textbook Macroeconomics: Institutions, Instability, and the Financial System (Oxford University Press) builds more than most other intermediate macroeconomics textbooks on supplying the student with a ‘systematic way of thinking through problems’ with the help of formal-mathematical models.

They explicitly adapt a ‘New Keynesian’ framework including price rigidities and adding a financial system to the usual neoclassical macroeconomic set-up. But although I find things like the latter amendment an improvement, it’s definitely more difficult to swallow their methodological stance, and especially their non-problematized acceptance of the need for macroeconomic microfoundations.

From the first page of the book they start to elaborate their preferred 3-equations ‘New Keynesian’ macro model. And after twenty-two pages they have already come to specifying the demand side with the help of the Permanent Income Hypothesis and its Euler equations.

But if people — not the representative agent — at least sometimes can’t help being off their labour supply curve — as in the real world — then in what way are these hordes of Euler equations that you find ad nauseam in these ‘New Keynesian’ macro models gonna help us?

My doubts regarding macroeconomic modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, Euler equations, and the PIH that they build on, don’t fit reality.

In the standard neoclassical consumption model — underpinning Carlin’s and Soskice’s microfounded macroeconomic modelling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? The Euler equation used implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Further, in the Euler equation we only have one interest rate, equated to the money market rate as set by the central bank. The crux is, however, that — given almost any specification of the utility function – the two rates are actually often found to be strongly negatively correlated in the empirical literature!

From a methodological perspective yours truly has to conclude that Carlin’s and Soskice’s microfounded macroeconomic model is a rather unimpressive attempt at legitimizing using fictitious idealizations — such as PIH and Euler equations — for reasons more to do with model tractability than with a genuine interest of understanding and explaining features of real economies.

Limiting model assumptions in economic science always have to be closely examined since if we are going to be able to show that the mechanisms or causes that we isolate and handle in our models are stable in the sense that they do not change when we ‘export’ them to our ‘target systems,’ we have to be able to show that they do not only hold under ceteris paribus conditions and hence only are of limited value to our understanding, explanations or predictions of real economic systems.

Mainstream economists usually do not want to get hung up on the assumptions that their models build on. But it is still an undeniable fact that theoretical models building on piles of known to be false assumptions — such as PIH and the Euler equations that build on it — in no way even get close to being scientific explanations.

So — mainstream macroeconomics, building on the standard neoclassical consumption model with its Permanent Income Hypothesis and Euler equations, has to be replaced with something else. Preferably with something that is both real and relevant, and not only chosen for reasons of mathematical tractability.

  1. Gerald Holtham
    March 10, 2021 at 2:11 pm

    Yes, “micro-founded” versions of the permanent income hypothesis are indeed a crock. Firstly even if individuals acted in the way specified it would not lead to a macro function of the same form. Secondly even viewed as a piece of “as-if” theorising, it is a failure. Econometric tests may have low power but they generally indicate the restrictions implied by the theory are rejected by the data. Duesenberry’s relative income hypothesis is more intuitively appealing but was rejected as being too sociological since it implied people were influenced by the consumption of others and was therefore sensitive to income distribution. In incorporating a ratchet effect it also threatened to introduce time dependency into the system. Those things that made it interesting and relevant were the cause of its rejection. It did not solve the aggregation problem however. You still can’t derive an aggregate function from a host of individual Duesenberrys. Here’s the problem: you can find stabilities in macroeconomic relations but without a theory you can’t specify or anticipate under what conditions the stabilities will break down. Choice-theoretic fairy stories about non-existent representative agents are not micro-foundations in anything other than name and do not constitute a theory.
    It is easy to state the problem and to reject the false “solution”. Resolving it is really difficult.

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