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, 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, 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.

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.

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

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