Permanent income hypothesis (1957)

Developed by American economist Milton Friedman (1912-1992), in its simplest form, permanent income hypothesis states that the choices consumers make regarding their consumption patterns are determined not by current income but by their longer-term income expectations.

Measured income and measured consumption contain a permanent (anticipated and planned) element and a transitory (windfall/unexpected) element. Friedman concluded that the individual will consume a constant proportion of his/her permanent income; and that low income earners have a higher propensity to consume; and high income earners have a higher transitory element to their income and a lower than average propensity to consume.

Also see: absolute income hypothesis, relative income hypothesis, life-cycle hypothesis

Source:
M Friedman, ‘A Theory of the Consumption Function’, National Bureau of Economic Research (Princeton, N.J., 1957)

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 years—their “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, depart from the traditional Keynesian emphasis on a higher marginal propensity to consume out of current income. 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.^[3]

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.

Origins

The American economist Milton Friedman developed the permanent income hypothesis (PIH) in his 1957 book A Theory of the Consumption Function.^[4] 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.

Theoretical considerations

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.

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, there are only two motives 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.