A Theory of the Consumption Function, With and Without Liquidity Constraints

F ifteen years ago, Milton Friedman’s 1957 treatise A Theory of the Consumption Function seemed badly dated. Dynamic optimization theory had not been employed much in economics when Friedman wrote, and utility theory was still comparatively primitive, so his statement of the “permanent income hypothesis” never actually specified a formal mathematical model of behavior derived explicitly from utility maximization. Instead, Friedman relied at crucial points on intuition and verbal descriptions of behavior. Although these descriptions sounded plausible, when other economists subsequently found multiperiod maximizing models that could be solved explicitly, the implications of those models differed sharply from Friedman’s intuitive description of his “model.” Furthermore, empirical tests in the 1970s and 1980s often rejected these rigorous versions of the permanent income hypothesis in favor of an alternative hypothesis that many households simply spent all of their current income. Today, with the benefit of a further round of mathematical (and computational) advances, Friedman’s (1957) original analysis looks more prescient than primitive. It turns out that when there is meaningful uncertainty in future labor income, the optimal behavior of moderately impatient consumers is much better described by Friedman’s original statement of the permanent income hypothesis than by the later explicit maximizing versions. Furthermore, in a remarkable irony, much of the empirical evidence that rejected the permanent income hypothesis as specified in tests of the 1970s and 1980s is actually consistent both with Friedman’s original description of the model and with the new version with serious uncertainty. There are four key differences between the explicit maximizing models