The Permanent Income Hypothesis in Economics

Hi there! Today I will define the last hypothesis among the three main hypotheses that attempt to explain consumer behaviour which is the 'Permanent Income Hypothesis'.

The permanent income hypothesis is an economic theory that suggests people's consumption patterns are determined by their long-term or permanent income, rather than their current income or short-term fluctuations in income. According to this theory, individuals will adjust their spending based on their expected lifetime income, rather than their current income or savings.

It was developed by economist Milton Friedman in the 1950s and 1960s. In his book "A Theory of the Consumption Function" (1957), Friedman argued that people do not spend all of their current income, but rather save some of it for future consumption. He believed that people base their spending decisions on their expected future income, which he called "permanent income."

An example to explain the permanent income hypothesis such as imagine someone who has a job that pays $50,000 per year. However, this person expects to receive a $20,000 inheritance in five years.
According to the permanent income hypothesis, this person would adjust their spending habits based on their expected permanent income of $70,000 per year, rather than their current income of $50,000 per year.

The permanent income hypothesis has been supported by empirical evidence over the years. For example, a study published in the Journal of Political Economy in 1988 found that households tend to smooth their consumption patterns over time, even in the face of short-term income fluctuations.

Another study published in the Journal of Monetary Economics in 1995 found that households tend to save a larger proportion of windfall income, such as lottery winnings than they do of regular income.

The implications of the permanent income hypothesis are important for policymakers and economists. If people base their spending decisions on their expected long-term income, rather than their current income, then policies that focus on short-term income boosts, such as tax rebates or stimulus checks, may not have as much impact on overall spending as policymakers might hope.

Instead, policies that focus on long-term income growth, such as education and training programs, may be more effective in promoting sustained increases in consumption and economic growth.

The permanent income hypothesis suggests that people's consumption patterns are determined by their expected long-term income, rather than their current income or short-term fluctuations in income.

This theory has important implications for policymakers and economists, who may need to focus on long-term income growth and stability in order to promote sustained increases in consumption and economic growth.

Thanks for reading my post. Hope that you like it.

Best Regards
@shahriar33

References:

Friedman, M. (1957). A Theory of the Consumption Function.
Carroll, C. D. (1988). Buffer-stock savings and the life cycle/permanent income hypothesis.
Jappelli, T., & Pistaferri, L. (1995). Using subjective income expectations to test for excess sensitivity of consumption to predicted income growth.