3.10: Permanent Income Hypothesis

The Permanent Income Hypothesis (PIH), formulated by economist Milton Friedman, explains how individuals plan their consumption based on long-term income expectations rather than current earnings. This theory is fundamental for analyzing consumer behavior over time.

Friedman separated total income into two parts: permanent income and transitory income.

• Permanent income represents the average income individuals expect throughout their lives, accounting for predictable and stable earnings.
• Transitory income includes temporary changes, such as an unexpected commission or a one-time prize.

According to PIH, consumption decisions depend primarily on permanent income, while transitory income fluctuations are mostly saved.

Individuals aim to maintain a stable consumption pattern by smoothing spending over time. They achieve this by saving during periods of high transitory income and borrowing when facing short-term income drops.

For example, if a person receives a sudden payment for participating in a research study, they are more likely to save it rather than significantly alter their everyday spending habits.

When individuals perceive that a change in income is permanent, they adjust their consumption immediately to reflect their new expected lifetime resources. For instance, if a professional accepts a lower-paying but stable job, they would decrease their consumption promptly to align with their reduced permanent income.

Mathematically, the PIH suggests that the marginal propensity to consume (MPC) out of permanent income is close to one. This means that changes in permanent income translate almost entirely into changes in consumption. Conversely, the MPC out of transitory income is much smaller, indicating that people save a large portion of temporary earnings.

The Permanent Income Hypothesis provides key insights into saving behavior, helping economists and policymakers understand how individuals react to income changes. It emphasizes the importance of expectations and long-term planning in shaping consumption patterns across an individual's lifetime.

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.