Transitory versus Permanent Income
Incomes vary over people’s lives not only because of predictable life cycle variation but also because of random and transitory forces. One year a frost kills off the Florida orange crop, and Florida orange growers see their incomes fall temporarily At the same time the Florida frost drives up the price of oranges, and California orange growers see their income temporarily rise The next year the reverse might happen Just as people can borrow and lend to smooth out life cycle variation in income, they can also borrow and lend to smooth out transitory variation in income. To the extent that a family saves in good years and borrows (or depletes its savings) in bad years, transitory changes in income need not affect its standard of living. A family’s ability to buy goods and services depends largely Oil its Permanent income which is its normal, or average, income.
To gauge inequality of living ‘standards, the distribution of permanent income is more relevant than the distribution of annual income. Many economists believe that people base their consumption on their permanent income; as a result; inequality in consumption is one gauge of inequality of permanent income Because permanent income and- consumption are less affected by transitory changes in income, they are more equally is current income. ..
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