Front Matter A Theory of the Consumption Function, M Friedman

Tags: the manuscript, aggregate consumption, Permanent Income Hypothesis
Content: This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: A Theory of the Consumption Function Volume Author/Editor: Milton Friedman Volume Publisher: Princeton University Press Volume ISBN: 0-691-04182-2 Volume URL: http://www.nber.org/books/frie57-1 Publication Date: 1957 Chapter Title: Front Matter "A Theory of the Consumption Function" Chapter Author: Milton Friedman Chapter URL: http://www.nber.org/chapters/c4402 Chapter pages in book: (p. -20 - 0)
A I I- J lvii LT 0 N F R I E D FyI A N
is the exact nature of the consWuhmatption function? Can this term be defined so that it will be consistent empirical evidence and a valid winisthtrument in the hands of future economic researchers and policy makers? In this volume a distinguished American economist presents a new theory of the consumption function, tests it against extensive statistical material and suggests some of its signi-. ficant implications. to the new theory is its sharp Cdeisnttirnacl tion between two concepts of income, measured income, or that which is recorded for a particular period, and permanent income, a longer-period concept in terms of which consumers decide how much to spend and how much to save. Dr. Friedman suggests that the total amount spent on consumption is on the average the same fraction of permanent income, regardless of the size of permanent income. The magnitude of the fraction depends on variables such as interest rate, degree of uncertainty relating to occupation, ratio of wealth to income, family size, and so on. The hypothesis is shown tq be consistent with budget studies and time series data, and some of its ing implications are explored in the final chapter.
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A THEORY OF THE CONSUMPTION FUNCTION
NATIONAL BUREAU OF ECONOMIC RESEARCH NUMBER 63, GENERAL SERIES
A Theory of the Consumption Function MILTON FRIEDMAN University of Chicago
A STUDY BY THE NATIONAL BUREAU OF ECONOMIC RESEARCH, NEW YORK
OXFORD & IBH PUBLISHING CO.
New Delhi
Calcutta
Bombay
Copyright 1957 by Princeton University Press Indian Edition 1970 published by arrangement with the original publishers Princeton University Press, New Jersey, U.S.A. Rs. 10.00 For sale in India. Pakistan, Burma and Ceylon This book has been published with the assistance of the Joint Indian - American Textbook Programme. Published by Mohan Pr.imlani, Oxford & IBH Publishing Co., Oxford Bldg.., N-88 Connaught Circus, New Delhi-I and printed by 0. D.Makhija at the India Offset Press, New Delhi-27.
NATIONAL BUREAU OF ECONOMIC RESEARCH 1957
OFFICERS Gottfried Haberler, Chairman Arthur F. Burns, President George B. Roberts, Vice-President and Treasurer Solomon Fabricant, Director of Research Geoffrey H. Moore, Associate Director of Research William J. Carson, Executive Director
DIRECTORS AT LARGE Wallace J. Campbell, Director, Cooperative League of the USA Solomon Fabricant, New York University Albert J. Hettinger, Jr., Lazard Frиres and Company Oswald W. Knauth, Beaufort, South Carolina H. W. Laidler, Executive Director, League for Industrial Democracy Shepard Morgan, Norfolk, Connecticut George B. Roberts, Vice-President, The First National City Bank of New York Beardsley Rum!, New York City Harry Scherman, Chairman, Book-of-the-Month Club George Soule, Bennington College N. I. Stone, Consulting Economist. J. Raymond Walsh, New York City Joseph H. Willits, Director, The Educational Survey, University of Pennsylvania Leo Wolman, Columbia University Donald B. Woodward, Vick Chemical Company Theodore 0. Yntema, Vice-President--Finance, Ford Motor Company
DIRECTORS BY. UNIVERSITY APPOINTMENT
E. Wight Bakke, Yale Arthur F. Burns, Columbia Melvin G. de Chazeau, Cornell G. A. Elliott, Toronto Frank W. Fetter, Northwestern H. M. Groves, Wisconsin
Gottfried Haberler, Harvard Clarence Heer, North Carolina R. L. Kozelka,. Minnesota C. Arthur KuIp, Pennsylvania T. W. Schultz, Chicago Jacob Viner, Princeton
DIRECTORS APPOINTED BY OTHER ORGANIZATIONS Percival F. Brundage, American Institute of Accountants Harold G. 1-laicrow, American Farm Economic Association S. H. Ruttenberg, Congress of Industrial Organizations Murray Shields, American Management Association Boris Shishkin, American Federation of Labor Willard L. Thorp, American Economic Association W. Allen Wallis, American Statistical Association Harold F. Williamson, Economic History Association
RESEARCH STAFF
Moses Abramovitz
Thor Hultgren
Arthur F. Burns
John W. Kendrick
Morris A. Copeland
Simon Kuznets
David Durand
Clarence D. Long
Richard A. Easterlin
.
Ruth P. Mack
SOlomon Fabricant
use MIntz
Milton Friedman
Geoffrey H. Moore
Raymond W. Goldsmith
G. Warren Nutter
Millard Hastay
Lawrence H. Seltzer
W. Braddock Hickman
George J. Stigler
Daniel M. Hollana
Leo Woltuan
Herbert B. Woolley
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To Janet and David
I-,
Preface THE theory of the consumption function proposed in this book evolved over a number of years. During most of this period, I was not engaged in empirical work on consumption. Indeed, prior to writing this book, I had done none since 1935--37, when I was connected with the planning of the Study of Consumer Purchases. I nonetheless kept in close touch with empirical research on consumption, thanks to the combined accident of my wife's occasional interest in the field and of our joint friendship with Dorothy Brady. Mrs. Brady's unrivaled knowledge of the empirical evidence from family budget data, penetrating insights into their explanation, and deep understanding of the scientific problems involved in their analysis occasioned a series of conversations on the interpretation of consumption data, in which discussions Margaret Reid subse- quently joined. Miss Reid, with characteristic enthusiasm, persistence, and ingenuity proceeded to put to a critical test the hypothesis that had been evolving out of these conversations' (see Chapter VII). When it seemed to be passingthe test with flying colors, she pressed me to write up the underlying theory so that she could refer to it in a paper presenting her conclusions. This book is the result, and though my hand held the pen, and though I am fully responsible for all its defects, it is in essential respects a joint product of the group, each member of which not only participated in its development but read and criticized the manuscript in its various stages. The origin of the book may explain some features of it, in particular the extensive reliance on secondary sources for data and the almost complete absence of statistical tests of significance. An hypothesis like the one presented below is typically· a by-product of original empirical work; so it is in this case, but the original work was Mrs. Brady's and Miss Reid's, not my own. What systematic empirical work I did came after the development of the hypothesis, not before, and was directed at bringing together as wide a variety of data as I could with which to confront the hypothesis. It is a defect of this confrontation that I make so little use of objective statistical tests of significance. There are several reasons for this defect. First, many of the data do not lend themselves readily to such tests. For example, it would be necessary in some cases to go back to individual 'The earliest written version of the hypothesis I can find in my files is in a four page typescript dated June 8, 1951. ix
PREFACE
observations rather than to be content, as I have been, with means
of groups. Secondly, sampling fluctuations seem to me a minor
source of error, particularly in interpreting family budget data for
rather large samples, compared to both biases in the samples and
inadequacies for my particular purpose in the definitions and
the kind of information collected. In consequence, I have preferred
to place major emphasis on the consistency of results from different
studies and to cover lightly a wide range of evidence rather than to
examine intensively a few limited studies.'
I am indebted to Phillip Cagan for overseeing the computation of
the aggregate consumption functions described in section 3b of
Chapter V, as well as for much help in deciding what to compute,
and to Gary Becker for overseeing some of the computations in
Chapter 1V, as well as for helpful comments and suggestions on the
whole manuscript. Raymond Goldsmith was generous in making
available to me much. material from his pathbreaking study of savings
before it was in print as well as in commenting on an earlier manu-
script. James Tobin read an early draft of section 4 of Chapter VI,
corrected a number of errors I had made in it, provided some
additional computations now contained in that section, and made
helpful suggestions on other parts of the manuscript; I appreciate
very much both his assistance and the scientific and objective spirit
'that animated it. James Morgan kindly made available some of the
data used in Chapter 1V, and contributed some valuable comments
on them; Julius Margolis and Lawrence Klein were also, helpful in
this connection. I am indebted to the Division of Research and
Statistics, Board of Governors of the Federal Reserve System, in
particular to Homer Jones, Irving Schweiger, and John Frechtling
for making available to me data from the Surveys of Consumer
Finances and helping me to interpret them. In addition, Frechtlirig
read the entire manuscript and made many helpful criticisms.
A number of other friends have also read one or another version of
the manuscript and have been generous with helpful comments. The
late Richard Brumberg read an early version of the manuscript in its
entirety and made numerous valuable suggestions for its improvement
and expansion. Others to whom I am indebted for a similar service
are Morris Copeland, Solomon Fabricant, Malcolm Fisher, Irwin
Friend, Ruth Mack, Geoffrey Moore, S. J. Prais, George Stigler, and
Frederick Waugh.
The reader shares my debt to the editors of the National Bureau of
Ecoilomic Research and the Princeton University Press for their
editorial assistance and to H. Irving Forman for the preparation of
the charts. ,
MILTON FRIEDMAN
February 23, 1956
x
Contents
Preface
ix
CHAPTER
I. Introduction
3
II. The Implications of the Pure Theory of Consumer
Behavior
7
1. Complete Certainty
7
2. The Effect of Uncertainty
14
a. The Indifference Curve Diagram
14
b. Motives for Holding Wealth
0
16
3. The Relation between the Individual and the Aggregate
Consumption Function
18
III. The Permanent Income Hypothesis
20
1. The Interpretation of Data on the Income and
Consumption of Consumer Units
21
2. A Formal Statement of the Permanent Income
Hypothesis
25
3. The Relation between Measured Consumption and
Measured Income
-
31
IV. Consistency of the Permanent Income Hypothesis with
Existing Evidence on the Relation between Consumption
and Income: Budget Studies
38
1. Temporal Changes in Inequality of Income
39
2. Consumption-Income Regressions for Different Dates
and Groups
40
a. Temporal Differences
44
b. Differences among Countries
54
c. Consumption of Farm and Nonfarm Families
58
d. Occupational Characteristics of Families
69
e. Negro and White Families
79
f. A Digression on the Use of- Partial Correlation
in Consumption Research
85
3. Savings and Age
90
xi
CONTENTS
4. The Effect of Change in Income
97
a. The FSA Data
101
b. The Survey of Consumer Finances Data
104
c. The Significance of the Comparisons
108
Appendix to Section 4: The Effect of Change in Income
on the Regression of Consumption on Income
109
1. Permanent Income Change of Same Absolute Amount 109
2. Permanent Income Change of Same Percentage
113
V. Consistency of the Permanent Income Hypothesis with
Existing Evidence on the Relation between Consumption
and Income: Time Series Data
115
1. Recent Long-period Estimates of Aggregate Savings
for the United States
116
a. Their General Pattern
1 16
b. The Constancy of k*
119
2. Regressions of Consumption on Current Income
125
a. Effect of Period Covered
125
b. Effect of Form of Data
129
c. The Relation between Time Series and Budget
Elasticities
134
3. Regressions of Consumption on Current and Past
Income
137
a. Functions by Modigliani, Duesenberry, and Mack 137
b. Alternative Functions Fitted to Data for a Long
Period
142
Appendix to Section 3: Effect on Multiple Correlation of
Common Errors in Measured Consumption and
Current Income
152
VI, The Relation Between the Permanent Income and Rela-
tive Income Hypotheses
157
1. Relative Income Status Measured by Ratio of
Measured Income to Average Income
160
2. Relative Income Status Measured by Percentile
Position in the Income Distribution
163
3. The Basis for the Relative Income Hypothesis
167
4. The Relative versus the Absolute Income Hypothesis 169
a. Continuous Budget Data
b. Geographical Budget Comparisons
.
, 170 173
c. Summary. Evaluation of Evidence
181
xli
CONTENTS
VII. Evidence from Income Data on the Relative Importance of Permanent and Transitory Components of Income 183
1. A Method of Estimating
184
2. Empirical Evidence on
188
3. Comparison of Estimates of with Estimated Income
Elasticity of Consumption
190
4. Correlation of the Ratio of Savings to Income in
Consecutive Years
196
Appendix: Correlation between Savings Ratios in Two
Consecutive Years
197
VIII. A Miscellany
200
1. Regression of Income on Consumption .
200
2. Application of Permanent Income Hypothesis to
Individual Categories of Consumption
206
3. Relevance to the Analysis of the Distribution of
Income
209
4. Connection between the Permanent Income Hypo-
thesis and the Distribution of Wealth
210
5. Additional Tests of the Permanent Income Hypothesis 214
IX. Summary and Conclusion
22Q
1. summary statement of Hypothesis
222
2. Evidence on the Acceptability of the Permanent
Income Hypothesis
224
3. Generalizations about consumer behavior Based on
the Hypothesis
226
4. Implications of the Hypothesis for Research
230
5. Substantive Implications of the Hypothesis
233
a. economic development
233
b. Economic Fluctuations
236
Inde,(
241
xlii
List of Tables
1. Relation between Consumption and Income Based on
Budget Data, for Different Countries, Dates, and Groups
of Consumer Units
41
2. Comparison of Heights of Regressions in Current and Constant Prices, Eight Studies from 1888--1890 to 1950 45
3. Relation ·between Consumption and.Income for Farm and Nonfarm Consumer Units, 1935--1936, 1941, and 1948--1950 62
4. Dispersion of Measured Inc9me and Its Permanentand Transitory Components Relative to Mean Measured Income for Farm and Nonfarm Families, 1935--1936, 1941 67
5. Relation between Consumption and Income for Indepйndent Business, Farm, and Other Spending Units, 1948--1950 71
6. Income Elasticity of Consumption, and Relative Dispersion of Measured Income and Its Components by Occupational Groups, Native White Nonrelief Complete Families in
Three Cities, 1935--1936
74
7. Relation between Consumption and Income, and Relative
Dispersion of Measured Income and Its Components,
Native White and Negro Nonrelief Complete Families in
Selected Communities, .1935--1936
82
8. Relation of Savings and Income to Age of Head of
Spending Unit, United States, 1946
91
9. Relation Of Savings and Income to Age of Head of income
Unit, Great Britain, 1953
.
94
10. Comparison of Observed and Predicted Results for
Income-Change Classes, Farm
Administration
Sample of Farm Families
102
11. Comparison of Observed and Predicted Results for
Income-Change Classes, Based on Survey of Consumer
Finances Data, 1947 and 1948
.
106
12. Relation between Consumption and Income Based on
Time Series Data' for the· United States, for Different
Periods and Concepts of Consumption
126
xiv
LIST OF TABLES AND FIGURES
13. Marginal Propensities to Consume Computed from Four Different Forms of Time Series Data for the United States 132
14. Selected Measures Derived from Regressions of Con-
sumption on Current and Past Income Computed by
Modigliani, Duesenberry, and Mack, and Recomputed by
Ferber
140
15. Three Consumption Functions for the United States:
Regressions of Consumption on Current and Past Incomes,
Nonwar Years 1905 through 1951
147
16. Comparison of Relative and Absolute Income Hypotheses
for Different Groups of Communities, 1935--1936
178
17. Comparison of Relative and Absolute Income Hypotheses Based on analysis of variance for Two Groups of
Communities, 1935--1936
180
18. correlation coefficients between Incomes of Identical
Units in Different Years
187
19. Summary of Correlation Coefficients in Table 18 for. Three
Principal Bodies of Nonfarm Data
189
20. Alternative Estimates of and Other Data from Survey of
Consumer Finances, 1953 Reinterview Sample, for Three
Occupational Groups
195
21. Relative Dispersion of Measured Income and Measured ConsumptiOn and Their Permanent and Transitory Components, Based on Survey of Consumer Finances Data,
1947 and 1948
202
List of Figures·
1. Hypothetical Indifference .Curves and budget lines of a
Consumer Unit for Consumption in Two Time Units
8
2. Illustration of Alternative Interpretations of Permanent
Income
24
3. Hypothetical Relation between Measured Consumption
and Measured Income
34
4. Regressions of Consumption on Income, 1888--1890 and
1950, and the Relation between Mean Consumption and
Mean Income in Eight Studies
47
5. Regressions of Consumption on Income for the United States and the United Kingdom, Spending or Income Units. of One or More Persons, Urban plus Rural, United States,
1950, United Kingdom, 1951--1952
56
xv
LIST OF FIGURES
6. Regressions of Consumption on Income for Farm and Nonfarm Families, United States, 1935--1936 and 1941 59
7. Hypothetical Regressions of Consumption on Income for
Farm and Nonfarm Families
64
8. Consumption-Income Relations for Independent Business and Nonfarm Nonbusiness Spending Units, 1948--1950 70
9. Regressions of Consumption on Income for Native White
and Negro Nonrelief Families, Columbus, Ohio, and
Atlanta, Georgia, 1935--1936
81
10. Hypothetical Regressions for Groups Classified by Change
· in Income
99
11. Regression of Family Consumption on Income for Farm
Families, Five Income-Change Groups, 1942 ·
101
12. Regressions of Consumption on Income for Five Income-
Change Groups, based on Survey of Consumer Finances
Data, 1947 and 1948
105
13. Relation of Personal Consumption Expenditures per Capita to Personal Disposable Income per Capita,
1897--1949
117
14. Measured Disposable Income per Capita, and Consumption per Capita Measured and as Estimated from Three
RegressiOns, 1905--1949
148
15. Relation between Computed Income Elasticity of Con-
sumption and Computed ImpOrtance of Permanent Com-
ponent of Income
193
C)
xvi

M Friedman

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Title: Front Matter "A Theory of the Consumption Function"
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