The Keynesian concept of marginal propensity to consume (MPC) considers one’s preferred proportion of income to consume as fixed. Due to this assumption, it faced significant criticism during the 1960s and 70s. These criticisms created the suitable environment for the birth of the Life Cycle/Permanent Income Hypothesis (LCPIH).

Essentially, LCPIH combines two distinct hypotheses generated against the Keynesian concept of MPC: the Life Cycle Hypothesis and the Permanent Income Hypothesis.

Life Cycle Hypothesis

The Life Cycle Hypothesis, developed by Franco Modigliani, argues that one’s expected lifetime income plays a crucial role in their consumption decisions. For instance, a student who is currently making an investment in human capital might borrow money and spend more during their university years based on their expectations of future earnings.

This naturally challenges the Keynesian MPC concept, which assumes that people spend a fixed proportion of their income on consumption.

Permanent Income Hypothesis

The Permanent Income Hypothesis, developed by Milton Friedman, puts forward another argument that criticizes the Keynesian concept of MPC: People tend to change their marginal propensity to consume according to the permanence of their income change.

If one’s income change is long-term, they tend to spend a larger proportion of their income compared to a short-term change. For instance, a wage raise will result in a larger increase in one’s consumption compared to a bonus of the same amount.

Complementary Frameworks

These two hypotheses complement each other, as they both propose a dynamic MPC ratio during one’s lifetime. LCPIH draws attention to the external factors’ effects on an individual’s marginal propensity to consume.

Expectations, plans, confidence matter. The future matters.

The challenge LCPIH poses against the Keynesian concept of a fixed MPC ratio is quite strong and well-founded. Not only theoretical rationality but also empirical data supports the claims made by LCPIH against the Keynesian MPC concept[^1].

Implications for Fiscal Policy

LCPIH indicates that fiscal policy instruments may not be as effective as suggested by the Keynesian frameworks, which were based on a fixed MPC ratio. If consumers perceive government payments as temporary, they will spend a lesser proportion of the received amount than expected, diminishing the expected multiplier effect.

LCPIH also emphasizes the importance of trust and stability. It suggests that policies resulting in lasting changes to income or wealth are likely to enhance the marginal propensity to consume among individuals. This indicates that structural reforms designed to achieve long-term economic growth may prove to be more effective in boosting overall consumption compared to short-term fiscal policies.

The Role of Expectations

Additionally, LCPIH accentuates the significance of expectations in economic behavior. The effectiveness of policies is heavily contingent upon how households perceive and interpret changes in policy. This understanding has prompted a greater focus on the clear communication of policy objectives and the establishment of forward guidance as a strategic policy instrument.

Conclusion

In conclusion, the LCPIH provides a clearer and more realistic way of thinking about MPC. Its arguments create a basis for more effective policies to speed up or slow down the economy, by taking psychology and expectations into consideration too.

[^1]: Source: Federal Reserve Board, 2008