Definition
The Permanent Income Hypothesis is an economic theory developed by Milton Friedman suggesting that consumers spend based on their perception of long-term, or “permanent”, income rather than current income. It proposes that people smooth out their consumption patterns over their lifetime and save or borrow based on expected changes in income. This is why temporary changes or fluctuations in income do not significantly influence spending habits according to this hypothesis.
Key Takeaways
- The Permanent Income Hypothesis, proposed by Milton Friedman, suggests that consumers’ spending decisions are not influenced by current income but instead by their long-term income expectations. They plan their spending based on what they perceive as their “permanent” income.
- The hypothesis separates income into two components: permanent and transitory. Permanent income refers to the average income level that an individual expects to have over a longer period, while transitory income refers to any temporary deviations from the permanent income.
- Implication of this hypothesis is that temporary changes in income have less effect on consumption patterns compared to permanent changes. This can explain why short-term tax breaks or one-off payments might not significantly influence consumer spending habits as predicted by simple income-consumption models.
Importance
The Permanent Income Hypothesis, proposed by economist Milton Friedman, is a vital concept in finance due to its insights into consumer spending behaviors.
It suggests that an individual’s consumption and saving decisions are not determined by current income.
Instead, they are influenced by their expected lifetime income, termed as their ‘permanent income.’ This implies that people adjust their expenditure based on this anticipated income and tend to smooth consumption, saving during high earnings periods and dis-saving during low earnings.
Understanding this hypothesis is crucial for policymakers and economists to analyze spending patterns, assess economic stability, and formulate effective fiscal measures.
It also underscores the importance of consumer confidence in future income and overall economic outlook in relationship to consumption and economic growth.
Explanation
The Permanent Income Hypothesis serves as a guiding principle in understanding the consumer consumption patterns over a long time horizon. It plays a central role in economic forecasting, policymaking, and in building economic models.
This concept provides insights about how consumers make spending decisions, not solely based on their current income, but also based on their expectations of future income. This knowledge helps businesses plan their production, marketers strategize their sales, and government form the fiscal policies.
Furthermore, the Permanent Income Hypothesis is an essential instrument in macroeconomic analysis and development. It aids economists in examining the effects of fiscal policies on consumption, thus predicting economic growth or contraction.
It helps to assess the efficacy of different economic policies or interventions like tax cuts or stimulus packages. Such insights from the Permanent Income Hypothesis can inform more effective strategies for managing economic conditions and enhancing societal welfare.
Examples of Permanent Income Hypothesis
Financial Planning and Retirement Savings: According to the Permanent Income Hypothesis, individuals will plan their consumption and savings based on their expected income over their lifetime. Hence, people might save more during their working years to maintain a certain standard of living during retirement. For example, if an individual anticipates a high income in life, they might not save as much in their early career but would increase their savings as they approach retirement.
Income Fluctuations: Some professions, such as real estate agents or freelance artists, don’t have a fixed steady income but rather experience significant income fluctuations. Consistent with the Permanent Income Hypothesis, they are likely to smooth their consumption across periods of high and low income, rather than increasing spending during good times and drastically cutting back during bad times. This implies that during periods of high income, these individuals will save more to maintain consumption during periods of lower income.
Unexpected Windfalls: Let’s say a person wins a large amount in the lottery. This is unexpected income, not likely to recur, hence according to the Permanent Income Hypothesis, most people would save or invest a larger portion of this windfall rather than significantly increasing their consumption as they understand that this is not a recurring addition to their regular income.
FAQ: Permanent Income Hypothesis
1. What is the Permanent Income Hypothesis?
The Permanent Income Hypothesis is an economic theory that people base their spending on both their current income and their expected future income. And therefore, they will save or borrow in anticipation of future changes in income.
2. Who proposed the Permanent Income Hypothesis?
The Permanent Income Hypothesis was proposed by Milton Friedman in 1957.
3. What are the implications of the Permanent Income Hypothesis?
This hypothesis implies that changes in income do not have a significant impact on consumption as temporary income shocks are smoothed out by saving or borrowing. This could have important implications for fiscal policy design.
4. How does the Permanent Income Hypothesis differ from the Relative Income Hypothesis?
The Relative Income Hypothesis suggests that individuals’ spending is more determined by their income relative to others, while the Permanent Income Hypothesis asserts that spending is defined by an individual’s own expected income over the long-term.
5. Does Permanent Income Hypothesis apply to all consumers?
The applicability of the Permanent Income Hypothesis differs for each individual. For some consumers, particularly those with lower income levels or less access to credit, spending may be more constrained by current income. However, for many consumers, particularly those with higher income levels or more access to credit, the hypothesis may be a valid description of consumption behaviour.
Related Entrepreneurship Terms
- Life-Cycle Hypothesis
- Consumption Behavior
- Transitory Income
- Consumer Spending
- Expected Future Income
Sources for More Information
- Investopedia: A comprehensive online resource for financial terms and theories. Here, their explanation on Permanent Income Hypothesis can be found.
- Encyclopedia Britannica: An online encyclopedia that provides a wealth of knowledge on various subjects, including economic theories like the Permanent Income Hypothesis.
- Economics Help: This website provides simple explanations for complex economic theories and terms, which may help to understand the Permanent Income Hypothesis.
- Corporate Finance Institute: This is an excellent resource for understanding financial terms and theories, including the Permanent Income Hypothesis.
