Permanent Income Hypothesis

Definition

The permanent income hypothesis is an economic theory proposed by Milton Friedman that suggests individuals base their consumption choices on their expected long-term average income rather than their current income. This theory emphasizes that people will smooth their consumption over time, planning for future income changes while reacting less to temporary fluctuations in income. It has important implications for understanding consumer behavior, savings, and economic policies.

5 Must Know Facts For Your Next Test

1. Milton Friedman developed the permanent income hypothesis in the 1950s as a way to explain why consumer spending does not fluctuate as much as current income does.
2. According to this hypothesis, people tend to save more during periods of higher income to maintain consistent consumption levels during times of lower income.
3. The theory implies that short-term economic policies aimed at boosting current income may have limited effects on overall consumption behavior.
4. Empirical evidence supports the idea that individuals use expectations about their future earnings to guide their present consumption decisions.
5. Friedman's work has influenced how economists understand the relationship between income, savings, and consumption in macroeconomic analysis.

Review Questions

• How does the permanent income hypothesis explain consumer behavior during periods of economic fluctuation?
  • The permanent income hypothesis explains that consumers do not react strongly to short-term changes in their income because they base their spending on long-term expected average income. This means when there are temporary increases or decreases in income, consumers may choose to save or borrow instead of adjusting their consumption drastically. As a result, overall consumer spending tends to be more stable, even in the face of economic fluctuations.
• Discuss how the permanent income hypothesis challenges traditional views on the relationship between current income and consumption.
  • The permanent income hypothesis challenges traditional views by suggesting that consumption is not solely determined by current income levels. Instead, it posits that individuals consider their anticipated lifetime earnings when making consumption decisions. This challenges the idea that temporary income changes should lead to proportional changes in spending, emphasizing a more complex interaction between expected future income and actual spending patterns.
• Evaluate the implications of the permanent income hypothesis for fiscal policy aimed at stimulating consumer spending during economic downturns.
  • The implications of the permanent income hypothesis for fiscal policy indicate that efforts to stimulate consumer spending through direct financial aid or tax cuts may be less effective than anticipated if individuals perceive these measures as temporary. Since consumers are likely to focus on their long-term financial outlook, they might save the additional funds rather than increase spending significantly. This suggests that policymakers should consider strategies that influence long-term expectations and incomes rather than relying solely on short-term stimulus measures to encourage consumption.

Related terms

Consumption Function: A concept that describes the relationship between consumer spending and disposable income, indicating how much households are likely to consume at different income levels.

Marginal Propensity to Consume (MPC): The proportion of additional income that a household is likely to spend on consumption as opposed to saving.

Life-Cycle Hypothesis: A theory that suggests individuals plan their consumption and savings behavior over the course of their lifetime, taking into account expected future income and expenses.