2. What is Permanent Income
Hypothesis ?
The Permanent income hypothesis (PIH) states that
individuals will spend money at a level relative to their
estimated long-term earnings. Consumers view a specific
level of income as permanent or recurring. The theory
implies that one cannot predict variations in consumer
behavior as such changes occur due to individual
expectations. Milton Friedman developed this theory in
1957.
3. Friedman divided the current measured
earnings or the actual income into two
categories — transitory income (YT) and
permanent income (YP). Hence, Y = YP + YT.
The transitory component has an estimated
value of 0, reflecting the assumption that future
transitory losses offset the transitory gains over
time.
Explanation:
4. As a result, observed income levels (Y) are equal to YP. Finally,
according to PIH, consumption expenditure is proportional to YP,
i.e., C = kYP, where ‘k’ is a constant representing the average
propensity to consume or APC and marginal prospensity to
consume or MPC.
The theory describes the consumption function (shown with the blue line) more
precisely as a long-run consumption function in accord with the long run behavior of
5. Case for Transitory Income :
The transitory income for different earnings groups explains observed
short-run results of consumer behavior. Specifically, the theory assumes
the transitory income for groups of individuals with low income to be
negative. This reflects the assumption that transitory losses are more than
transitory gains for these groups. This means YT < 0 or YTL < YPL.
In the case of middle-income groups, the transitory income becomes 0
over time, such that permanent and observed income have the same
value. This means YTM = 0 or YM = YPM.
Lastly, in the case of high-income groups, the transitory gains are more
than the transitory losses such that the value of transitory income is
positive on average over time. This means YTH > 0 or YH >YPH.
6. As one can observe in the graph, developing a short-run
consumption function (red line) is possible using this transitory
component’s impact.
The permanent income hypothesis of consumption offers a
framework to understand how households might react to the
7. Example :
Let us look at this permanent income hypothesis example to
understand the concept better.
Suppose a worker named Gary expects to get a bonus at the
end of the financial year. It might be reasonable to think that his
spending before receiving the bonus might change in
anticipation of the extra income. However, according to this
theory, he may choose not to spend more solely because of the
windfall income. Instead, he might want to increase his savings.
