Permanent income hypothesis

The permanent income hypothesis (PIH) is an economic theory attempting to describe how
agents spread consumption over their lifetimes. First developed by Milton Friedman,[1] 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 yearstheir "permanent income". In
its simplest form, the hypothesis states that changes in permanent income, rather than changes
in temporary income, 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, departs from the traditional Keynesian emphasis on the marginal propensity to
consume. It 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.[2]
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; 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, i.e. their permanent
income, will be less than their current income.
Contents
The American economist Milton Friedman developed the permanent income hypothesis (PIH) in
his 1957 book A Theory of the Consumption Function.[1] As classical Keynesian consumption
theory was unable to explain the constancy of savings 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.
Theoretical considerations[edit]
Permanent income hypothesis is the theory of consumption eventually. 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 marginal propensity to consume. However, since 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, marginal propensity to
consume is in a reverse relation with real income. It must be stressed that the relation

characterized by substantial stability links current consumption expenditures to current

disposable incomeand, 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, of course. According to the basic theory of Keynes, governments are
always capable of countercyclical fine-tuning of macroeconomic systems through demand
management.
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 Friedmanin 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, there are only two motives for a consumer unit to spend more or less on consumption
than its income: The one 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 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 processthat is, consumer units try
to optimize not only across periods but within each period.
We have a fundamentally different framework if expectations are rational (REH). Under these
circumstances, not only some past but also all information about the future available at the
moment is utilized in forming expectations about permanent income. To revise the level of
consumption expenditures it is not enough to realize the changes in current income, since if this
shift could be foreseen, rationally expecting agents built this development into their expectations
in advance. It has to be mentioned that consumption follows a random walk path under REH.[3]