A key feature of modern macroeconomic models is the emphasis on expectations in determining the effects of government policies. One aspect of expectations is Milton Friedman's Permanent Income Hypothesis (PIH). Friedman's PIH assumes

1) People base their current consumption on the income they earn today and the income they earn in the future i.e. their lifetime or permanent income.

2) People prefer smooth even consumption flows over time. PIH implies a person with an uneven flow of income over time, will use financial markets (borrowing and saving money) to create an even flow of consumption. Rational Expectations 1.png An unemployed person who wins the lottery today is represented by [ Select ] (A, B, C). An unemployed person who has rich parents who have left him a large inheritance that he will we receive when he turns 30 is represented by [ Select ] (A, B, C). According to the PIH, both people will use financial markets, ie. borrow or lend, to move to [ Select ] (A, B, C) because people prefer to even out their consumption over time. According to the PIH, [ Select ] (x>y, x=y, x