Permanent Income Hypothesis

The Permanent Income Hypothesis, developed by Milton Friedman, explains how individuals plan their consumption by considering expected long-term income rather than just current income.

Friedman divided income into two components: a permanent component, which represents the lifetime average income an individual expects, and a transitory component, which reflects temporary fluctuations such as bonuses or unanticipated tax refunds and stimulus checks.

According to the hypothesis, individuals base their everyday consumption primarily on their permanent income, maintaining a relatively stable consumption path. When they receive transitory income, they tend to save most of it.

The model assumes that individuals form expectations rationally based on available information. They aim to keep their spending steady by saving when they earn more and borrowing when they earn less.

However, if they believe that an income drop is permanent, they adjust their consumption downward immediately.

Mathematically, consumption depends primarily on permanent income. Here, k represents the fraction of permanent income that individuals choose to consume in each period.