Generalizing the Permanent-Income Hypothesis: Revisiting Friedman's Conjecture on Consumption
Friedman's contribution to the consumption literature goes well beyond the seminal permanent-income hypothesis. He conjectured that the marginal propensity to consume out of financial wealth shall be larger than out of "human wealth," the present discounted value of future labor income. I present an explicitly solved model to deliver this widely-noted consumption property by specifying that the conditional
variance of changes in income increases with its level. A larger realization of income not only implies a higher level of human wealth, but also signals a riskier stream of future labor income, inducing a higher precautionary saving, and thus giving rise to Friedman's conjecture. Appropriately adjusting human wealth for income risk,
I show that Friedman's conjecture may be formulated as a "generalized" permanent income hypothesis. I further show that Friedman's conjecture captures the first-order effect of stochastic precautionary savings. Finally, I propose a natural decomposition of the optimal saving rule to formalize various motives for holding wealth as emphasized in Friedman, M., 1957. A Theory of the Consumption Function. Princeton University Pree, Princeton.
Source: Journal of Monetary Economics
Wang, Neng. "Generalizing the Permanent-Income Hypothesis: Revisiting Friedman's Conjecture on Consumption." Journal of Monetary Economics 53, no. 4: 737-52.