Transition Events in the Dynamics of Poverty. Permanent Income and Life-Cycle Hypotheses


The permanent income and life-cycle hypotheses—associated primarily with Nobel prize winners Modigliani and Friedman—highlight the important role of unearned income and future earned income, as well as current income (Dornbusch and Fischer 1990). An advantage of the permanent income and life-cycle hypotheses, over the human capital theory, is that they incorporate both earned and unearned income. The foundation of the theories is that people have a permanent income stream (from current and future earnings and assets), but that their income can have short-term (transitory) deviations from the permanent stream. Lillard and Willis (1978) propose the components-of-variance method as a link between poverty data and the life cycle framework of these hypotheses. Several researchers use this method to try and measure the permanent and transitory components of income and poverty (Lillard and Willis; Duncan and Rodgers 1991; Stevens 1999). However, the theory is difficult to adapt to poverty (Bane and Ellwood 1986) and results from the empirical model do not reproduce observed patterns of poverty persistence as well as other methods (Stevens 1999). In addition, the permanent income hypothesis does not allow for an individual’s income stream to change if, for example, they become disabled. This is a serious drawback for analyzing poverty transitions where one of the primary aims is to analyze the effect of events—such as a change in disability or marital status—on poverty.

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