Final answer:
Keynes assumed current consumption depended on disposable income, but the permanent income hypothesis suggests it also involves future income expectations and wealth. Individuals practice consumption smoothing by spreading out consumption over time to maintain a consistent standard of living.
Step-by-step explanation:
In the context of consumption theories, the permanent income hypothesis contrasts with Keynesian views on what determines current consumption. Keynes assumed that current consumption depended largely on disposable income, which is the income after taxes that individuals have available for spending and saving.
According to Keynes, disposable income is the most powerful determinant of consumption. However, the permanent income hypothesis introduces the notion that it is not merely the current income that affects consumption but also expected future income and accumulated wealth. For instance, an increase in wealth or expectations of future income would lead to an increase in current consumption, even if current disposable income does not change.
Moreover, the idea of consumption smoothing, as illustrated by the example of inheriting $10 million, indicates that individuals spread out their consumption over time in response to changes in income to achieve a stable standard of living. If this windfall is expected to last ten years, the person might only increase their annual consumption by $1 million, reflecting a marginal propensity to consume of 0.1.