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Permanent Income Hypothesis

Definition

The Permanent Income Hypothesis is an economic theory that suggests individuals base their consumption spending on their anticipated lifetime income, rather than their current income. This theory, proposed by Milton Friedman, assumes that people are forward-thinking and so they spend money based on what they consider their standard of living to be over the long-term. Therefore, temporary fluctuations in income won’t significantly affect spending habits.

Phonetic

The phonetics for the keyword “Permanent Income Hypothesis” is as follows:Permanent: /ˈpɜːr.mə.nənt/Income: /ˈɪn.kʌm/Hypothesis: /haɪˈpɒθ.ɪ.sɪs/

Key Takeaways

  • The Permanent Income Hypothesis, proposed by Milton Friedman, suggests that consumers’ spending decisions are not solely determined by their current income, but by their expectation of their lifetime or permanent income.
  • According to this theory, people will try to maintain a fairly stable standard of living, smoothing their consumption throughout their lifetime, saving during periods of high income and dissaving in periods of low income.
  • The key implication of the Permanent Income Hypothesis is that changes in consumption should be less volatile than changes in income due to temporary income fluctuations, as consumers anticipate future income and spend or save accordingly.

Importance

The Permanent Income Hypothesis is a pivotal concept in business/finance as it influences individual consumption patterns and subsequently affects market trends. Proposed by Milton Friedman, it suggests that people’s consumption decisions are determined not by current income but by their longer-term income expectations. In essence, individuals plan their consumption and savings behavior over the long term, taking into account their lifetime resources. This hypothesis is crucial for understanding consumer behavior in the economy, informing monetary policy decisions, designing economic models, and predicting the effects of fiscal policies on consumption. It particularly helps to explain the apparent contradiction between low income-high consumption and high income-low consumption scenarios.

Explanation

The Permanent Income Hypothesis is a theory of consumption proposed by economist Milton Friedman, which serves as a benchmark for understanding consumer spending patterns over time. Its primary purpose is to explain and predict how households make consumption decisions based on their perceived long-term economic position rather than their current income. It essentially suggests that people’s consumption at any given point is determined not by current income but by what they consider their “permanent income”. Permanent income is not the actual annual income but what consumers perceive as their long-term average income.

When it comes to practical application, the Permanent Income Hypothesis has significant implications for both economic policy and financial planning. For policy-making, understanding this hypothesis aids in predicting the impacts of certain fiscal measures. For instance, according to this theory, a temporary tax cut may not encourage significant increases in spending because people perceive this as a short-term increase in their income and tend to save more instead of expanding consumption. Similarly, in personal financial planning, it aids in advising people who experience income fluctuations, like contractors or freelancers, to manage their consumption and saving properly through apprehending their permanent income rather than just their current earnings.

Examples

1. College Students: The permanent income hypothesis can be seen clearly with college students. Despite having low current incomes, they often have high levels of spending because they expect their permanent income to be higher in the future once they graduate and start their careers. They take loans and live a lifestyle that is not aligned with their current income, but with their expected future income.

2. Retirement Planning: The retirement planning strategy of many individuals can also reflect the Permanent Income Hypothesis. Many people save a significant portion of their income during their working years in anticipation of a time where their income will be reduced or non-existent. They are making decisions based on their lifetime or ‘permanent’ income, not just what they earn in a particular year.

3. Ups and Downs in Business Earnings: In the business world, many entrepreneurs may experience years of low income or even loss while their businesses are still growing. However, they continue to invest in their business based on the expectation (or hope) that in the long term, the business will be profitable, and their permanent income will be higher. This expected higher permanent income influences their spending and saving decisions during the period of lower income.

Frequently Asked Questions(FAQ)

What is the Permanent Income Hypothesis?

The Permanent Income Hypothesis is a theory conceived by economist Milton Friedman suggesting that people’s decisions on consumption and saving are driven by their expected lifetime income rather than their current income.

Who proposed the Permanent Income Hypothesis?

The Permanent Income Hypothesis was introduced by Nobel-prize winning economist Milton Friedman in 1957.

How does the Permanent Income Hypothesis work?

The theory assumes that individuals make their consumption decisions based on what they perceive to be their permanent income. This includes a long-term average of their income, rather than their current weekly or monthly income, which may fluctuate.

How does the Permanent Income Hypothesis impact consumer behavior?

The Permanent Income Hypothesis explains that consumers will try to smooth their consumption over their lifetime. They will save when income is high, so they can spend when income is low, thereby maintaining a fairly consistent standard of living.

What does the Permanent Income Hypothesis say about savings?

According to this hypothesis, savings don’t necessarily increase with a temporary increase in earnings. This is because people consider their lifetime income rather than current income; therefore, they may not increase savings proportionately with any temporary income boost.

Why is the Permanent Income Hypothesis important in economics?

The Permanent Income Hypothesis plays a crucial role in economics as it helps to understand consumer behaviour, particularly in relation to consumption and saving. This helps economists and policymakers to predict the effects of fiscal policy and understand the drivers behind aggregate demand.

Can the Permanent Income Hypothesis be used for financial planning?

Yes, it can be used as a principle for individual financial planning. It suggests that one should plan their consumption and saving based on their estimated income over their lifetime, rather than their immediate income.

What are the criticisms of the Permanent Income Hypothesis?

Critics argue that the Permanent Income Hypothesis overlooks liquidity constraints and myopic behavior of individuals. Not everyone has access to credit to smooth consumption when income is low, and individuals may not always act rationally or have a perfect foresight of their future income.

Related Finance Terms

  • Consumption Smoothing
  • Life Cycle Hypothesis
  • Marginal Propensity to Consume
  • Income Fluctuation
  • Expected Future Income

Sources for More Information

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