Permanent income hypothesis

Permanent income hypothesis
See also
Labor supply curve Autonomous consumption Consumption function Diminishing marginal utility Rational expectations theory Income effect Competitive equilibrium Theory of consumption Indifference curve and budget line

The Permanent Income Hypothesis (PIH) is an economic theory proposed by Milton Friedman in 1957 that suggests that consumer spending is determined not by current income but by an individual's expected or permanent income. In other words, it states that individuals base their consumption decisions on their expected future income rather than on their current income. This means that households will adjust their expenditure in response to changes in their expected future income, rather than changes in their current income. In other words, consumers will adjust their spending in response to changes in their expected future income, rather than changes in their current income.

The PIH can be broken down into several components:

• The income effect: This refers to how a change in expected future income can affect a consumer's current consumption.
• The intertemporal substitution effect: This refers to how a consumer will substitute current consumption for future consumption.
• The wealth effect: This refers to how changes in wealth, such as a rise in the stock market, can affect a consumer's current consumption.

Example of Permanent income hypothesis

For instance, if a consumer expects to receive a substantial raise in the near future, they may adjust their consumption in response to this expected future income. This could mean that they decrease their current consumption and save more money in anticipation of this future raise.

On the other hand, if a consumer expects to receive a large inheritance in the near future, they may increase their current consumption in anticipation of this future income. This could mean that they buy more luxury items and take more vacations in anticipation of receiving this future inheritance.

Formula of Permanent income hypothesis

The Permanent Income Hypothesis can be mathematically represented as follows:

$C=P_{0}+{\frac {Y_{t}-Y_{0}}{1+r}}$

Where C is current consumption, P₀ is permanent income, Y_t is current income, Y₀ is the expected income in the future, and r is the expected rate of return. This formula suggests that current consumption is a function of the difference between current income and expected future income, which is adjusted for the expected rate of return.

When to use Permanent income hypothesis

The Permanent Income Hypothesis can be used to explain and predict consumer spending behaviour. It can be used to explain why consumers may engage in certain spending patterns and how their spending may be affected by changes in their expected future income. Additionally, it can be used to predict how consumers may respond to changes in their expected future income, such as tax cuts or increases in wages. Finally, the PIH can help to explain why consumers may choose to save in order to obtain a more secure future income.

Advantages of Permanent income hypothesis

The Permanent Income Hypothesis provides several advantages in the field of economics.

• Reduced consumption volatility: The PIH suggests that consumption is more stable, since the consumer is basing their decisions on their expected future income rather than on their current income.
• Increased savings rate: The PIH also suggests that households will increase their savings rate, since they are basing their decisions on expected future income rather than on current income.
• Increased economic stability: By reducing the volatility of consumption and increasing the savings rate, the PIH increases economic stability.

Limitations of Permanent income hypothesis

The Permanent Income Hypothesis has several limitations.

• It assumes that people are rational, meaning that they make decisions based on expected utility maximization rather than on impulse.
• It assumes that people have perfect foresight and can predict future income accurately.
• It assumes that all people have the same preferences and therefore the same consumption patterns.
• It assumes that people have access to all available information and can make accurate decisions based on this information.

Other approaches related to Permanent income hypothesis

In addition to the Permanent Income Hypothesis, there are several other approaches related to it. These are:

• The Life Cycle Hypothesis (LCH): This suggests that individuals use their income over their lifetime to smooth out their consumption.
• The Permanent Income Disutility Hypothesis (PIDH): This suggests that individuals will attempt to maintain a certain level of consumption over their lifetime and that they will use their income to balance out any differences in their current and desired levels of consumption.
• The Random Income Hypothesis (RIH): This suggests that individuals' consumption decisions are based on their current income, rather than their expected future income.

Overall, the Permanent Income Hypothesis is an important economic theory that offers an explanation of how consumer spending is determined by an individual's expected future income. Other approaches related to this theory include the Life Cycle Hypothesis, the Permanent Income Disutility Hypothesis, and the Random Income Hypothesis, each of which provide further insight into how consumer spending can be influenced by current and expected future income.

Suggested literature

• Friedman, M. (1957). The permanent income hypothesis. In A theory of the consumption function (pp. 20-37). Princeton University Press.
• Bewley, T. (1976). The permanent income hypothesis: A theoretical formulation. Harvard Univ Cambridge Mass.
• Hall, R. E. (1978). Stochastic implications of the life cycle-permanent income hypothesis: theory and evidence. Journal of political economy, 86(6), 971-987.