Explain how the permanent income hypothesis reconciles the difference between short-run and long-run consumption behavior.

According to the life cycle hypothesis the short-run consumption function shows a decline average propensity to consume (APC) while the long-run consumption function exhibits constant average propensity to consume due to increase in asset base. On the other hand permanent income hypothesis explains the discrepancy in terms of permanent income and transitory income.

Friedman’s permanent income hypothesis provides an alternative explanation to the apparent discrepancy between cross-sectional and time series data on consumption. Unlike the life-cycle hypothesis, Friedman does not postulate that incomes follow a regular pattern over the life cycle of an individual; he instead argues that individuals experience random and temporary changes in their income from time to time. Accordingly, Friedman views the current income in any period (Y_t) as consisting of _________ _______ _______ ______ __________ ______ ______ _____.
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