permanent income hypothesis
Quick Summary
The permanent income hypothesis, developed by economist Milton Friedman, is a theory in economics that explains consumer spending. It suggests that individuals base their spending not just on their current income, but on their expected long-term income, which Friedman termed "permanent income."12
This hypothesis posits that people tend to smooth their consumption over time. Therefore, temporary changes in income (windfalls or unexpected losses) have a smaller impact on spending than permanent changes. For instance, if someone receives a one-time bonus, they are likely to save a significant portion of it rather than spend it all immediately. However, if they receive a promotion that permanently increases their salary, their spending will increase more substantially.12
The permanent income hypothesis is a simplified version of the life-cycle theory, focusing on how individuals allocate their resources over time to maintain a stable level of consumption.12
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- consumption function
…model, known as the “permanent income hypothesis,” which abstracts from retirement saving decisions. The figure shows the consumption function that emerges from a standard version of the permanent income hypothesis (assuming uncertain future income and a standard “utility function” that specifies consumers’ attitudes toward the level and riskiness of…
Read More…model, known as the “permanent income hypothesis,” which abstracts from retirement saving decisions. The figure shows the consumption function that emerges from a standard version of the permanent income hypothesis (assuming uncertain future income and a standard “utility function” that specifies consumers’ attitudes toward the level and riskiness of…
Read More - consumptionThe rational optimization framework
…optimization framework called the “permanent income hypothesis,” whose origins trace back to economist Milton Friedman’s treatise A Theory of the Consumption Function (1957). The permanent income hypothesis omits the detailed treatment of demographics and retirement encompassed in the life-cycle model, focusing instead on the aspects that matter most for…
Read More…optimization framework called the “permanent income hypothesis,” whose origins trace back to economist Milton Friedman’s treatise A Theory of the Consumption Function (1957). The permanent income hypothesis omits the detailed treatment of demographics and retirement encompassed in the life-cycle model, focusing instead on the aspects that matter most for…
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