Permanent Income Hypothesis

The permanent income hypothesis is a theory of consumption developed by Milton Friedman, which holds that individuals base their consumption on their permanent income, the average income that they expect to receive over their lifetime, rather than on their current income.

The Theory

The theory distinguishes between permanent income, which is the average income that the individual expects to receive over the long run, and transitory income, which is the deviation of current income from the permanent level. The theory holds that consumption is determined by permanent income.

The implication is that consumption does not respond to transitory changes in income, since the individual smooths consumption over time. A temporary increase in income is saved rather than consumed, and a temporary decrease is financed by dissaving.

The theory treats the individual as forward-looking, allocating consumption over the lifetime to maximise utility subject to the lifetime budget constraint. The optimal allocation equates the marginal utility of consumption across periods, subject to the rate of interest and to the discount rate.

Evidence

The evidence provides qualified support for the theory. The finding that consumption responds less to transitory income than to permanent income is supported by studies of the response of consumption to windfalls and to temporary tax changes.

The theory has been challenged by the finding that consumption is more sensitive to current income than the theory predicts, a result known as excess sensitivity. The finding has been explained by liquidity constraints, which prevent individuals from borrowing against future income, and by the behaviour of consumers who do not optimise.

The theory has also been extended to include precautionary saving, in which individuals save to protect against uncertainty about future income. The extension improves the fit of the theory and explains the accumulation of wealth by households with uncertain income.

Implications

The theory has implications for the analysis of the effects of fiscal policy. A temporary tax cut, which raises transitory income, should have little effect on consumption, while a permanent tax cut should have a larger effect.

The theory also has implications for the analysis of the effects of social security and of other transfer programmes. The design of the programmes affects the permanent income of households and thereby their consumption.

The theory represents the modern approach to consumption, in which the behaviour of households is analysed in a forward-looking framework with attention to the constraints and to the uncertainty that they face.

The Life Cycle Hypothesis

The life cycle hypothesis, developed by Franco Modigliani, is closely related to the permanent income hypothesis. The hypothesis holds that individuals plan their consumption and savings over their lifetime, smoothing consumption by saving during the working years and dissaving during retirement.

The hypothesis implies that consumption depends on the lifetime resources of the individual rather than on current income. The pattern of saving over the life cycle reflects the desire to smooth consumption.

The hypothesis has been tested extensively, and the evidence provides qualified support. The pattern of saving over the life cycle is consistent with the hypothesis, though the behaviour of the elderly is less consistent with the predictions of the simple model.

Liquidity Constraints

The presence of liquidity constraints is a major qualification to the permanent income hypothesis. Individuals who cannot borrow against their future income are unable to smooth consumption, and their consumption responds to current income.

The constraints are particularly relevant for young households, which have low current income and high expected future income but limited collateral. The constraints explain the finding of excess sensitivity of consumption to current income.

The presence of the constraints has implications for the effects of policy. A temporary tax cut may be saved by households that are not constrained but consumed by those that are, and the aggregate effect depends on the share of the constrained households.

Precautionary Saving

The presence of uncertainty about future income leads to precautionary saving, in which individuals save to protect against the risk of a decline in income. The saving raises the wealth of the households and affects the response of consumption to income.

The precautionary saving is stronger when the uncertainty is higher and when the individuals are more risk averse. The presence of the saving helps to explain the accumulation of wealth by households with uncertain income.

The extension of the model to include precautionary saving improves the fit with the data and provides a richer account of consumption behaviour.

Summary

The permanent income hypothesis holds that consumption is determined by the lifetime resources of the individual rather than by current income. The theory has been extended to account for liquidity constraints, for precautionary saving, and for the behaviour over the life cycle, and the extensions improve its fit with the data.

See also

• Consumer Behaviour
• Macroeconomics
• Keynesian Economics