Dependence of Consumption on Wealth, not Income
Neutrality
Other than its contribution to a consumer’s wealth, current income has no independent effect on the consumption of a utility-maximizing consumer.
Wealth- The value of current assets plus the discounted value of future earnings
Friedman’s View
Friedman’s view is in support of the neutrality
Friedman looks at the two-period Irving Fisher model U(c1,c2), which looks at a consumer’s spending over two periods
C1 = current consumption in the first period C2 = consumption in the second period
When maximizing U(c1,c2) a dollar earned in period 1 has the same effect on current consumption as an equivalent discounted dollar earned in period 2. Therefore, consumption will depend solely on the discounted value of current and future income and the interest rate.
Permanent Income- the amount of wealth that can be spent without its depletion
Permanent Income Hypothesis- consumption is affected by permanent, not current income
Keynes’ View
Keynes’ work came before Friedman’s, and is contradictory of the neutrality
Keynes believes that current income does have a direct effect on current consumption
Fundamental Psychological Law- “men are disposed, as a rule and on the average, to increase their consumption as income increases, but not by as much as the increase in income.” (Keynes, The General Theory)
Keynes also believed that other components of wealth (expected future income and interest rate) affected current consumption; however, consumption is more sensitive to changes in current income
The Missing Motivations in Macroeconomics | Ricardian Equivalence | The Modigliani-Miller Theorem | Natural Rate Theory | Rational Expectations
