The permanent income hypothesis (PIH) is a model in the field of
economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics anal ...
to explain the
formation of consumption patterns. It suggests consumption patterns are formed from future expectations and
consumption smoothing. The theory was developed by
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
and published in his ''A Theory of Consumption Function'', published in 1957 and subsequently formalized by
Robert Hall in a
rational expectations model. Originally applied to
consumption and
income
Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. Fo ...
, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income (
human capital
Human capital is a concept used by social scientists to designate personal attributes considered useful in the production process. It encompasses employee knowledge, skills, know-how, good health, and education. Human capital has a substantial ...
,
property
Property is a system of rights that gives people legal control of valuable things, and also refers to the valuable things themselves. Depending on the nature of the property, an owner of property may have the right to consume, alter, share, r ...
,
asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
s), rather than changes in temporary income (unexpected income), are what drive changes in consumption.
The formation of consumption patterns opposite to predictions was an outstanding problem faced by the
Keynesian orthodoxy. Friedman's predictions of
consumption smoothing, where people spread out transitory changes in income over time, departed from the traditional
Keynesian
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
emphasis on a higher
marginal propensity to consume out of current income.
Income
Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. Fo ...
consists of a permanent (anticipated and planned) component and a transitory (unexpected and surprising) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not their current income. Unlike permanent income, transitory incomes are volatile.
Background and history
Until ''A Theory of Consumption Function'', the Keynesian
absolute income hypothesis and interpretation of the
consumption function were the most advanced and sophisticated. In its
post-war
In Western usage, the phrase post-war era (or postwar era) usually refers to the time since the end of World War II. More broadly, a post-war period (or postwar period) is the interval immediately following the end of a war. A post-war period ...
synthesis
Synthesis or synthesize may refer to:
Science Chemistry and biochemistry
* Chemical synthesis, the execution of chemical reactions to form a more complex molecule from chemical precursors
**Organic synthesis, the chemical synthesis of organ ...
, the
Keynesian perspective was responsible for
pioneering many innovations in recession management, economic history, and macroeconomics. Like the
neoclassical school that preceded it, early inconsistencies had their roots in socio-political events contrary to the predictions put forward.
The introduction of the absolute income hypothesis is often attributed to
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
, a British
economist
An economist is a professional and practitioner in the social sciences, social science discipline of economics.
The individual may also study, develop, and apply theories and concepts from economics and write about economic policy. Within this ...
, who wrote several books which are now the basis for Keynesian economics. The hypothesis put forward by Keynes was accepted and placed into the post–war synthesis. However, inconsistencies were not resolved swiftly, and economists were unable to explain the consistency of the
savings rate
Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as rec ...
in the face of
rising real incomes (Fig. 1).
Before the
neoclassical synthesis
The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Key ...
was established,
Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in m ...
and his hypothesis challenged the orthodoxy of
neoclassical economics
Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good ...
. As a result of the
Great Depression
The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
, Keynes rapidly became among the leaders of economic thought. His
MPC and
MPS spending multipliers developed into the absolute income hypothesis (), and were influential to the government responses to the ensuing depression.
Origins
The American
economist
An economist is a professional and practitioner in the social sciences, social science discipline of economics.
The individual may also study, develop, and apply theories and concepts from economics and write about economic policy. Within this ...
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
developed the permanent income hypothesis in his 1957 book ''A Theory of the Consumption Function''. In his book, Friedman posits a theory that explained how and why future expectations change consumption.
Friedman's 1957 book created the basis for
consumption smoothing. He argued the consumption model, in which outcomes are
stochastic
Stochastic (, ) refers to the property of being well described by a random probability distribution. Although stochasticity and randomness are distinct in that the former refers to a modeling approach and the latter refers to phenomena themselv ...
, where consumers face risks and
uncertainty
Uncertainty refers to epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to physical measurements that are already made, or to the unknown. Uncertainty arises in partially observable ...
to their
labor incomes, complicates interpretations of
indifference curve
In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is ''indifferent''. That is, any combinations of two products indicated by the curve will provide the c ...
s, and causes consumers to spread out or 'smooth' their spending based on their permanent income, which represents their anticipated income over their lifetimes. Friedman explain in ''A Theory of the Consumption Function'' how consumers interact with money based on not just
windfall gain
A windfall gain is an unusually high or abundant income, that is sudden and/or unexpected.
Types
Examples of windfall gains include, but are not limited to:
*Gains from demutualization - this example can lead to especially large windfall gains. ...
s, but through their permanent income because consumers will save when they expect their long term income to rise. He writes:
Theoretical considerations
In his theory,
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
supported economic policy makers by his argument emphasizing their capability of macroeconomic fine tuning. For Keynes, consumption expenditures are linked to disposable income by a parameter called the
marginal propensity to consume (the amount per dollar consumers are willing to spend;
). Since the marginal propensity to consume itself is a function of income, it is also true that additional increases in disposable income lead to diminishing increases in consumption expenditures. It must be stressed that the relation characterized by substantial stability links current consumption expenditures to current disposable income—and, on these grounds, a considerable leeway is provided for aggregate demand stimulation, since a change in income immediately results in a multiplied shift in aggregate demand (this is the essence of the Keynesian case of the
multiplier effect). The same is true of tax cut policies. According to the basic theory of Keynes, governments are always capable of countercyclical fine tuning of macroeconomic systems through demand management, although Friedman disputes this, arguing in a 1961 journal article that Keynesian macroeconomic fine tuning will succumb to 'long and variable lags.'
The permanent income hypothesis questions this ability of governments. However, it is also true that permanent income theory is concentrated mainly on long run dynamics and relations, while Keynes focused primarily on short run considerations. Friedman's argument, which challenged the use of
fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection ( taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variabl ...
in smoothing out
business cycles, was challenged by stressing the relation between consumption and disposable income still follows (more or less) the mechanism supposed by Keynes.
Friedman starts elaborating his theory under the assumption of complete certainty. Under such circumstances, for Friedman, two motives exist for a consumer unit to spend more or less on consumption than its income: The first is to smooth its consumption expenditures through appropriate timing of borrowing and lending; and the second is either to realize interest earnings on deposits if the relevant rate of interest is positive, or to benefit from borrowing if the interest rate is negative.
According to the PIH, the distribution of consumption across consecutive periods is the result of an optimizing method by which each consumer tries to maximize his utility. At the same time, whatever ratio of income one devotes to consumption in each period, all these consumption expenditures are allocated in the course of an optimization process—that is, consumer units try to optimize not only across periods but within each period.
Calculation of income and consumption
Friedman's 1957 book also made an argument for an entirely new way of calculating income (income is represented by the variable
) by differentiating between transitory and permanent income (which was also taken to include ordinal elements like human capital and talents). In ''A Theory of Consumption Function'', Friedman develops:
as a formula. In an earlier study, Friedman, Kuznets (1945), he proposes the idea of transitory and permanent income.
Friedman also developed a consumption formula,
, with
meaning the permanent component of consumption, with
being the transitory component. Friedman also drew a distinction between
and
. Transitory consumption can be interpreted as surprising or unexpected bills, such as a high water bill, or unexpected doctor's visit, which, in Friedman's mind, cannot be spurred by
, because unexpected or 'surprise' consumption is not often financed through windfall gains.
Simple model
Consider a (potentially infinitely lived) consumer who maximizes his expected lifetime utility from the consumption of a stream of
goods
In economics, goods are items that satisfy human wants
and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not ...
between periods
and
, as determined by one period
utility function
As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosoph ...
. In each period
, he receives an income
, which he can either spend on a consumption good
or save in the form of an asset
that pays a constant
real interest rate in the next period.
The utility of consumption in future periods is
discounted at the rate
.
Finally, let