Permanent Income Hypothesis

Definition

The Permanent Income Hypothesis (PIH) is an economic theory proposed by economist Milton Friedman. This hypothesis suggests that consumers' consumption decisions are primarily based on their long-term expected income (permanent income) rather than current short-term income fluctuations. According to the Permanent Income Hypothesis, consumers smooth their consumption levels through saving and borrowing to cope with short-term income changes, making their consumption patterns more stable.

Origin

The Permanent Income Hypothesis was introduced by Milton Friedman in 1957 as a supplement and correction to traditional consumption theories. Friedman's research indicated that consumer behavior is more dependent on long-term income expectations rather than short-term income changes, a view that garnered significant attention and discussion in the field of economics.

Categories and Features

The main features of the Permanent Income Hypothesis include:
1. Long-term Perspective: Consumers' consumption decisions are based on their long-term income expectations rather than current income fluctuations.
2. Consumption Smoothing: Consumers strive to maintain a stable consumption level through saving or borrowing, even when income fluctuates in the short term.
3. Saving and Borrowing: Consumers increase savings when income is high and borrow when income is low to maintain a stable consumption level.
4. Income Classification: Income is divided into permanent income and temporary income, with permanent income referring to a sustainable long-term income level and temporary income referring to short-term income fluctuations.

Case Studies

Consider an individual who expects their long-term income (permanent income) to be $50,000 annually, but in one year, due to bonuses and other short-term factors, their income reaches $70,000. According to the Permanent Income Hypothesis, this person would not significantly increase their consumption but would save the extra $20,000 to use in future years when income might fall below $50,000, thus maintaining consumption stability.

Another example is an employee receiving an extra year-end bonus during an economic boom. According to the Permanent Income Hypothesis, the employee might choose to save or invest this bonus rather than spend it immediately, to maintain their living standard during economic downturns.

Common Issues

Investors applying the Permanent Income Hypothesis might encounter issues such as:
1. Over-reliance on long-term income expectations, potentially missing opportunities from short-term income changes.
2. Planning savings and borrowing effectively to smooth consumption when income is highly volatile.