The permanent income hypothesis, wealth inequality, and anti-recessionary stimulus

I asked before, “If someone handed you $10 right now, what would you do with it? Would you decide to spend it right away? Or would you stash it away? Or some combination of the two?” How you answer that hypothetical would reveal your marginal propensity to consume. But why do people have different marginal propensities to consume? The way economists have long thought about this concept is through the perspective of the “permanent income hypothesis,” an idea advanced by famed University of Chicago economist Milton Friedman. The hypothesis states that an individual’s consumption depends less on their income today (their transitory income) and more on their lifetime income (their permanent income).

Yet as economics columnist Noah Smith writes, some empirical work shows some big flaws in the hypothesis. So it’s worth thinking through the hypothesis and how inequality, specifically wealth inequality, influences consumption.

The permanent income hypothesis posits that if you’re handed $10 right now, whether you spend it today depends less on how much income you took in today (perhaps only $10) and more on how much you’re going to make over the course of your life. Hopefully, $10 is a drop in the bucket compared to your lifetime earnings so you’re unlikely to spend much of that extra money. But as Smith points out, there’s a good amount of research that shows people will spend a decent amount of surprise money when they receive it. So what’s going on here?

The answer lies in who is most likely to spend that additional money. There are well-known variations in the marginal propensities to consume. People with lower net worth tend to have higher marginal propensities to consume, while these propensities decline as a person’s net worth increases. More specifically, research points to the importance of liquid wealth, or wealth that a person can readily access. The research shows that people who consume a decent chunk of new income are likely to be less wealthy.

Perhaps these less wealthy people have less access to credit and can’t borrow funds to finance their consumption. Regardless of the reason, if people with few liquid assets are quick to spend cash they receive, then this has important implications for fiscal policy. If policymakers want to make sure that the money they appropriate to fight a recession gets spent quickly, then they want to get it to the people with few or no liquid assets. These are the ones who will actually spend it, boosting consumption and helping to restart economic growth.