Permanent income hypothesis
The permanent income hypothesis (often abbreviated PIH) is an economic theory attempting to describe how agents spread consumption over their lifetimes. First developed by Milton Friedman in his 1957 book A Theory of the Consumption Function, it supposes that a person's consumption at a point in time is determined not just by their current income, but also by their expected income in future years—their "permanent income". In its simplest form, the hypothesis states that changes in permanent income, rather than changes in temporary income (an example of temporary income is a windfall gain), are what drive the changes in a consumer's consumption patterns. Its predictions of consumption smoothing, where people spread out transitory changes in income over time, depart from the traditional Keynesian emphasis on a higher marginal propensity to consume out of current income. The Permanent Income Hypothesis has had a profound effect on the study of consumer behavior, and provides an explanation for some of the failures of Keynesian demand management techniques.
Income consists of a permanent (anticipated and planned) component and a transitory (windfall gain/unexpected) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not his current income.
Permanent income is defined as expected long term average income.
Assuming consumers experience diminishing marginal utility, they will want to smooth out consumption over time, e.g. take on debt as a student and also ensure savings for retirement. Coupled with the idea of average lifetime income, the consumption smoothing element of the PIH predicts that transitory changes in income will have only a small effect on consumption. Only longer lasting changes in income will have a large effect on spending.
A consumer's permanent income is determined by their assets: physical (property), financial (shares, bonds) 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, i.e. their permanent income, will be less than their current income.
The American economist Milton Friedman developed the permanent income hypothesis (PIH) in his 1957 book A Theory of the Consumption Function. As classical Keynesian consumption theory was unable to explain the constancy of the saving rate in the face of rising real incomes in the United States, a number of new theories of consumer behavior emerged. In his book, Friedman posits a theory that encompasses many of the competing hypotheses at the time as special cases and presents statistical evidence in support of his theory.
Friedman's 1957 book created the basis for this theory of consumption smoothing. He argued that the consumption model, in which outcomes are randomly determined (stochastic), where consumers face risks and uncertainty to their labour incomes, will cause consumers to spread out or "smooth" their spending based off of their permanent income that is, the anticipated income over a period of time.
Friedman explain in A Theory of the Consumption Function how consumers interact with money based off of not just windfall gains i.e. inheriting money or receiving unexpected cash but through their permanent income because consumers will likely only save when their long term average income rises. He writes:
Yet from another point of view, the assumption seems highly implausible. Will not a man who receives an unexpected windfall use at least some part of it in "riotous living," i.e. in consumption expenditures? Would he be likely to add the whole of it to his wealth? The answer to these questions depends greatly on bow "consumption" is defined. The offhand affirmative answer reflects in large measure, I believe, an implicit definition of consumption in terms of purchases, including durable goods, rather than in terms of the value of services. If the latter definition is adopted, as seems highly desirable in applying the hypothesis to empirical data—though unfortunately I have been able to do so to only a limited extent—much that one classifies offhand as consumption is reclassified as savings. Is not the windfall likely to be used for the purchase of durable goods? Or, to put it differently, is not the timing of the replacement of durable goods and of additions to the stock of such goods likely to some extent to be adjusted so as to coincide with windfalls?
In his theory, John Maynard Keynes supported economic policy makers by his argument emphasizing their capability of macroeconomic fine tuning. The only problem was that actual consumption time series were much less volatile than the predictions derived from the theory of Keynes. For Keynes, consumption expenditures are linked to disposable income by a parameter called the marginal propensity to consume. However, since the marginal propensity to consume itself is a function of income, it is also true that additional increases in disposable income lead to diminishing increases in consumption expenditures. In other words, the marginal propensity to consume has an inverse relation with real income. It must be stressed that the relation characterized by substantial stability links current consumption expenditures to current disposable income—and, on these grounds, a considerable leeway is provided for aggregate demand stimulation, since a change in income immediately results in a multiplied shift in aggregate demand (this is the essence of the Keynesian case of the multiplier effect). The same is true of tax cut policies. According to the basic theory of Keynes, governments are always capable of countercyclical fine tuning of macroeconomic systems through demand management, although Friedman disputes this, saying that Keynesian macroeconomic fine tuning will succumb to "long and variable lags".
The permanent income hypothesis questions this ability of governments. However, it is also true that permanent income theory is concentrated mainly on long run dynamics and relations, while Keynes focused primarily on short run considerations. The emergence of the PIH raised serious debates, and the authors tried either to verify or to falsify the theory of Friedman—in the latter case, arguments were directed mainly towards stressing that the relation between consumption and disposable income still follows (more or less) the mechanism supposed by Keynes. According to some hints dropped in the literature, PIH has the advantage (among others) that it can help us resolve the (alleged) inconsistency between occasionally arising large scale fluctuations of disposable income and the considerable stability of consumption expenditures. Friedman starts elaborating his theory under the assumption of complete certainty. Under these conditions, a consumer unit precisely knows each definite sum it will receive in each of a finite number of periods and knows in advance the consumer prices plus the deposit and the borrowing rates of interest that will prevail in each period. Under such circumstances, for Friedman, two motives exist for a consumer unit to spend more or less on consumption than its income: The first is to smooth its consumption expenditures through appropriate timing of borrowing and lending; and the second is either to realize interest earnings on deposits if the relevant rate of interest is positive, or to benefit from borrowing if the interest rate is negative. The concrete behaviour of a consumer unit under the joint influence of these factors depends on its tastes and preferences.
According to the PIH, the distribution of consumption across consecutive periods is the result of an optimizing method by which each consumer tries to maximize his utility. At the same time, whatever ratio of income one devotes to consumption in each period, all these consumption expenditures are allocated in the course of an optimization process—that is, consumer units try to optimize not only across periods but within each period.
Consider a (potentially infinitely lived) consumer who maximizes his expected lifetime utility from the consumption of a stream of goods between periods and , as determined by one period utility function . In each period , he receives an income , which he can either spend on a consumption good or save in the form of an asset that pays a constant real interest rate in the next period.
The utility of consumption in future periods is discounted at the rate . Finally, let denote expectation conditional on the information available in period . Formally, the consumer's problem is then
Assuming that the utility function is quadratic, and that , the optimal consumption choice of the consumer is governed by the Euler equation
Given a finite time horizon of length , we set with the understanding the consumer spends all his wealth by the end of the last period. Solving the consumer's budget constraint forward to the last period, we determine that the consumption function is given by
Over an infinite time horizon, we instead impose a no Ponzi game condition, which prevents the consumer from continuously borrowing and rolling over his debt to future periods, by requiring
The resulting consumption function is then
Both expressions (1) and (2) capture the essence of the permanent income hypothesis: current consumption is determined by a combination of current non human wealth and human capital wealth . The fraction of total wealth consumed today further depends on the interest rate and the length of the time horizon over which the consumer is optimizing.
In standard models of the PIH, the Permanent Income Hypothesis is unable to explain the unrealisticassumption that consumers can borrow or lend without any limitations, rather than the behavioral assumptions that are often criticized in other models. Some have attempted to correct Friedman's original hypothesis by including liquidity constraints, most notably Christopher D. Carroll.
An early test of the permanent income hypothesis was reported by Robert Hall in 1978. Hall notes that if previous consumption was based on all information consumers had at the time, past income should not contain any additional explanatory power about current consumption above past consumption. This prediction is supported by the data, which Hall interprets as support for a slightly modified version of the permanent income hypothesis. Hall and Frederic Mishkin (1982) analyze data from 2,000 households and find that consumption responds much more strongly to permanent than to transitory movements of income and that the PIH is compatible with 80% of households in the sample. Ben Bernanke (1984) finds "no evidence against the permanent income hypothesis" when looking at data on automobile consumption.
In contrast, Marjorie Flavin (1981) finds that consumption is very sensitive to transitory income shocks ('excess sensitivity'), a rejection of the PIH. Greg Mankiw and Matthew Shapiro (1985) however dispute these findings, arguing that Flavin's test specification (which assumes that income is stationary) is biased towards finding excess sensitivity.
Nicholas Souleles (1999) uses income tax refunds to test the PIH. Since a refund depends on income in the previous year, it is predictable income and should thus not alter consumption in the year of its receipt. The evidence finds that consumption does indeed respond to the income refund, with a marginal propensity to consume between 35–60%. Melvin Stephens (2003) finds that the consumption patterns of social security recipients in the United States is not well explained by the PIH.
Many of the rejections of the PIH emphasize the importance of liquidity constraints. This places a focus not on the PIH's behavioral and psychological assumptions, but rather on its ancillary assumption that consumers can easily borrow or lend. Because this assumption is unrealistic, critics have claimed Permanent Income Hypothesis is unrealistic. This insight has led to adjustments of the simplest PIH model to account for capital market imperfections and restraints, such as liquidity constraints. Some of these adjustments to the PIH, such as the buffer stock version of Christopher Carroll (1997) have added further evidence supporting consumption smoothing. A comprehensive meta analysis of 3000 tests of the permanent income hypothesis reported in 144 studies found that many rejections of the PIH are due to publication bias and that, after correction for publication bias, the PIH is consistent with data.
The PIH helps explain the failure of transitory Keynesian demand management techniques to achieve its policy targets. In a simple Keynesian framework the marginal propensity to consume (MPC) is assumed constant, and so temporary tax cuts can have a large stimulating effect on demand. The PIH framework suggests that a consumer will spread out the gains from a temporary tax cut over a long horizon, and so the stimulus effect will be much smaller. The Permanent Income Hypothesis has evidence supporting such a view, such as a study by Shapiro and Slemrod, published in 2003.
The PIH helps challenge what Friedman later called "naive Keynesian theory", by proving how, in his view, government spending was less efficient at stimulating the economy, compared to tax cuts and other proposals.
Many of the critics of PIH cite the failure of Friedman's original model to adapt to market imperfections, most notably liquidity restraints. Because the theory rests on the assumption that consumers can, with ease, borrow or lend, which is unrealistic, some critics have claimed that PIH fails due to liquidity restraints. However, many studies have been adapted for this and found that PIH is compatible with liquidity constraints and other market imperfections.
- Consumption smoothing
- Income#Economic definitions
- Milton Friedman
- Ricardian equivalence
- Risk compensation
- Milton Friedman bibliography
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- "Do consumers really follow a rule of thumb? Three thousand estimates from 144 studies say "probably not"". Review of Economic Dynamics, forthcoming.
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