The permanent income hypothesis is a theory of consumer spending, proposing that individuals will spend money at a level consistent with their anticipated long-term average income. This expected long-term income forms what is considered the “permanent” income, guiding spending habits. Consequently, a worker will save if their current income exceeds the anticipated permanent income, providing a cushion against possible future income declines.
Key Takeaways
- The permanent income hypothesis posits that individuals spend in line with their expected long-term average income.
- Milton Friedman developed this theory, suggesting consumer spending hinges on expected future income rather than current after-tax income.
- Economic policies that increase income do not necessarily lead to increased consumer spending according to this hypothesis.
- An individual’s liquidity affects how they manage their income and spending.
Understanding the Permanent Income Hypothesis
Formulated by Nobel Prize-winning economist Milton Friedman in 1957, the permanent income hypothesis suggests that changes in consumption are unpredictable because they are based on personal expectations. This theory significantly impacts economic policy.
According to this theory, even successful economic policies that increase income may not trigger a multiplier effect on consumer spending. Increased consumer spending will only occur when workers adjust their expectations about their future incomes.
Friedman contended that individuals consume based on estimates of their future income, diverging from Keynesian economics which posits that consumption is based on current after-tax income. Friedman believed people prefer to “smooth” their consumption over time rather than letting it fluctuate due to short-term income changes.
How Spending Habits Reflect the Permanent Income Hypothesis
Consider a worker expecting an income bonus at the end of a pay period. Anticipating additional earnings, the worker might alter their spending habits before receiving the bonus. Alternatively, workers might choose not to increase spending solely due to a short-term financial windfall, choosing instead to save the extra income.
Similarly, individuals informed of an imminent inheritance might be inclined to change their expenditure patterns. However, according to the permanent income hypothesis, they may prefer to save or invest the additional funds for long-term growth rather than spend it immediately on consumable goods or services.
The Role of Liquidity in the Permanent Income Hypothesis
An individual’s liquidity, or their asset availability, can influence their future income expectations. Those without assets might not base their spending on either current or future income.
Over time, incremental salary increases or securing new long-term, higher-paying jobs can alter an individual’s permanent income. As expectations rise, their spending patterns may also elevate correspondingly.
Related Terms: income, Milton Friedman, economic policy, consumer spending, Keynesian economics, consumption smoothing, liquidity
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## Which economist is most closely associated with the Permanent Income Hypothesis?
- [ ] John Maynard Keynes
- [ ] Paul Samuelson
- [x] Milton Friedman
- [ ] Joseph Stiglitz
## What does the Permanent Income Hypothesis primarily suggest about consumer spending?
- [x] Consumers base their spending on an estimate of their permanent income rather than current income.
- [ ] Consumers spend all their current income.
- [ ] Consumers save the same fraction from each paycheck.
- [ ] There is no relation between income and spending.
## According to the Permanent Income Hypothesis, how do consumers typically react to a temporary increase in their income?
- [ ] They will increase their consumption significantly.
- [x] They will save most of the temporary increase.
- [ ] They will not change their consumption habits.
- [ ] They will take out more loans.
## If a consumer receives a one-time windfall, what does the Permanent Income Hypothesis predict they are likely to do?
- [ ] Spend all of it immediately.
- [ ] Use it to increase their current consumption.
- [x] Save or invest the majority, smoothing consumption over time.
- [ ] Pay down debts only.
## How does the Permanent Income Hypothesis differ from the Keynesian consumption function?
- [x] It accounts for the expectation of future income, while the Keynesian consumption function is based solely on current income.
- [ ] It suggests consumers spend more than they earn, while the Keynesian function suggests saving.
- [ ] It implies no difference in future income expectations across various consumers.
- [ ] It leads to higher marginal propensity to consume.
## Under the Permanent Income Hypothesis, who is more likely to have a stable consumption pattern?
- [x] Individuals with a predictable and steady permanent income.
- [ ] Individuals with fluctuating incomes.
- [ ] Only high-income earners.
- [ ] Those who adjust their lifestyle frequently.
## Which aspect does the Permanent Income Hypothesis ignore?
- [ ] Expected future income
- [ ] Long-term saving
- [ ] Investment returns
- [x] Short-term financial shocks
## What does the Permanent Income Hypothesis suggest about the marginal propensity to consume from temporary income?
- [ ] It is high.
- [ ] It has no impact.
- [ ] It is the same as permanent income.
- [x] It is low.
## What role do expectations play in the Permanent Income Hypothesis?
- [ ] No role.
- [ ] Dependent on current savings rate.
- [x] Major role, as consumers form expectations about their future income and base their spending accordingly.
- [ ] Only affects low-income groups.
## According to the Permanent Income Hypothesis, how is consumption affected by individual lifecycle stages (e.g., young, middle-aged, retired)?
- [ ] Consumption remains constant throughout all stages.
- [ ] Retirees will spend most aggressively.
- [x] Consumption is smoothed over an individual's lifetime based on expected permanent income.
- [ ] Young individuals will consume much more than their income.
