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, depart 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. c t = r ( 1 + r ) − ( 1 + r ) − ( T − t ) [ A t + ∑ k = 0 T − t ( 1 1 + r ) k E t ⁡ [ y t + k ] ] . {displaystyle c_{t}={frac {r}{(1+r)-(1+r)^{-(T-t)}}}left ight].}     (1) c t = r 1 + r [ A t + ∑ k = 0 ∞ ( 1 1 + r ) k E t ⁡ [ y t + k ] ] . {displaystyle c_{t}={frac {r}{1+r}}left ight].}     (2) 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, depart 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.