Formulated by Franco Modigliani of MIT.
1. The theory basically says that individuals plan their consumption and savings behaviour over the long term with a view of allocating incomes in the best possible way over their entire lifetimes. 2. This implies different marginal propensities to consume out of permanent income, transitory income (temporary) and wealth. 3. The basic idea is that individuals will spend the different incomes differently with a view to maintain stable lifestyles i.e. individuals try and consume and save the same amount each year. For example : a person starts working at 20, works till 65 and dies at 80. Annual labour income (YL) is $30,000. Lifetime resources are thus spread over 45 years (65-20 ) and this is known as the working life or WL. Thus, total lifetime resources are 45 x 30000 = 1,350,000. Spreading these resources over an entire lifetime i.e over (80-20) = 60 years means an average annual consumption of $22,500 i.e. 1,350,000/60. Thus consumption C = (WL/NL) x YL
WL - Working life (i.e. 65-20 = 45 years)
NL - number of years of life (80 – 20 = 60 years)
YL - Annual labour income (YL) is $30,000
4. Thus the marginal propensity to consume is given by WL/NL. 5. Suppose income was to rise by $3000 in every year. Thus total income increase multiplied by mpC is (45/60) x 3000 = $2250 increase in consumption every year. 6. But if income increase only by $ 3000 in one year then increase in consumption would be spread over 60 years; thus (1/60) x 3000 = $50. 7. MPC out of the $3000 increase in one year is 1/60 = 0.017. The clear message is that MPC out of permanent income is large while MPC out of transitory income is fairly small and close to 0. 8. Also the spending out of wealth is same as transitory income and has a lower MPC>