Permanent income hypothesis
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The permanent income hypothesis (PIH) is a theory of consumption that assumes rational behavior by agents. In its simplest form, the hypothesis states that a change in permanent income, rather than a change in temporary income, affects the choices that determine a consumer's consumption patterns. The key conclusion of this theory is that transitory, temporary changes in income have little effect on consumer spending behavior, whereas permanent changes can have large effects on consumer spending behavior.
Measured income and measured consumption comprise a permanent (anticipated and planned) element and a transitory (windfall gain/unexpected) element. Friedman concluded that the individual consumes a constant proportion of their permanent income; and that low income earners consume a higher fraction of their income, i.e., they have a higher propensity to consume; and high income earners have a higher transitory element to their income and a lower than average propensity to consume.
In Friedman's permanent income hypothesis model, the key determinant of consumption is an individual's real wealth, not his current real disposable income. Permanent income, a.k.a. expected long-term average income, is determined by a consumer's assets; both physical (shares, bonds, property) and human (education and experience). These influence the consumer's ability to earn income. The consumer can then make an estimation of anticipated lifetime income. A worker saves only if they expect that their long-term average income, their permanent income, will be less than their current income. The fact that permanent income is a long-term average allows the researcher to ignore complicated questions of dynamic programming in solving the individual’s consumption path. As Palda writes “The constancy of discounted lifetime income also explains why people can uncouple the timing of income over the lifetime and the timing of their consumption. The sum of income in every year adds to a single number … Borrowing and lending merely serve to displace consumption through time, but not to increase its discounted value. This guarantees the constancy of the budget constraint and vastly simplifies the problem of how the consumer should adjust consumption over the life-time. If consumption decisions do not affect the budget constraint then the optimization problem boils down to a simple spreading of income evenly over time, moderated in part by interest rates, and in part by impatience and updating due to random shocks.” By summarizing the key factors determining consumption into a single datum, the permanent income hypothesis in effect banishes time from the inter-temporal analysis of consumption.
Transitory income is the difference between the measured income and the permanent income. It can be calculated simply by subtracting the measured income from the permanent income.
There is a corollary to the permanent income hypothesis named the permanent production hypothesis. This hypothesis stipulates that the choices made by producers regarding their production patterns are determined not by their present term capital cost but by their longer-term capital cost expectations. The key conclusion of this theory is that transitory, short term changes in capital costs have little effect on production behavior.
- Consumption smoothing
- Income#Meaning in economics and use in economic theory
- Milton Friedman
- Ricardian equivalence
- Robert Schenk, "Permanent-Income Hypothesis"