Permanent Consumption Hypothesis

The Permanent Income Hypothesis (PIH) is a theory in macroeconomics that suggests that people base their consumption decisions not on their current income, but on their long-term or “permanent” income. The PIH posits that individuals smooth their consumption over time, so that their consumption remains constant relative to their permanent income, even if their current income fluctuates.

The PIH was first proposed by the economist Milton Friedman in the 1950s as a way to explain the relationship between income and consumption. According to the PIH, consumption decisions are based on an individual’s expected long-term income, rather than their current income. In other words, people are assumed to have a target level of consumption that they aim to maintain, and they adjust their saving and borrowing behavior in response to changes in their income.

The PIH has several key implications for macroeconomic theory and policy.

• First, it suggests that consumption is less sensitive to changes in current income than to changes in permanent income. This implies that fiscal policies, such as tax cuts or stimulus payments, may have less impact on consumption than is commonly assumed, since they typically affect current income rather than permanent income.
• Second, the PIH implies that people may be more likely to save or borrow in response to changes in income than to adjust their consumption immediately. For example, if an individual receives a bonus at work, they may be more likely to save or invest the money rather than immediately increase their spending.
• Third, the PIH suggests that people may be more willing to take on debt if they expect their income to rise in the future. This is because they can smooth their consumption over time, borrowing when their income is low and paying back the debt when their income is high.

There are several key assumptions underlying the PIH.

• The first is that individuals have perfect foresight, meaning that they are able to accurately predict their future income and consumption levels. This assumption allows individuals to make optimal consumption and saving decisions over time.
• The second assumption is that people are rational and make decisions that maximize their lifetime utility. This implies that people are willing to adjust their consumption and saving behavior in response to changes in their income and other economic factors.
• The third assumption is that there are no liquidity constraints, meaning that individuals are able to borrow and lend at the same interest rate. This allows individuals to smooth their consumption over time, borrowing when their income is low and paying back the debt when their income is high.

Despite its usefulness in explaining consumption behavior, the PIH has been subject to several criticisms over the years. One criticism is that it assumes that people have perfect foresight, which is unrealistic in practice. In reality, people may not be able to accurately predict their future income or may face unexpected economic shocks that affect their income and consumption.

Another criticism of the PIH is that it assumes that people are rational and make decisions that maximize their lifetime utility. In reality, people may not always make optimal decisions, and may be subject to biases and other psychological factors that affect their consumption behavior.

A third criticism of the PIH is that it assumes that there are no liquidity constraints, meaning that individuals are able to borrow and lend at the same interest rate. In reality, people may face constraints on their ability to borrow or access credit, which can affect their consumption behavior.

Despite these criticisms, the PIH remains a useful framework for understanding consumption behavior and its implications for macroeconomic policy. It highlights the importance of permanent income in shaping consumption decisions, and suggests that people may be more willing to save or borrow in response to changes in income than to adjust their consumption immediately. It also has important implications for fiscal policy, suggesting that policies that affect permanent income, such as changes in tax rates or income transfers, may have a greater impact on consumption than policies that affect only current consumption behavior

Example in table

In this example, an individual’s current income (Yt) and permanent income (YP) are shown for each year from 2018 to 2022. The individual’s consumption (Ct) is also shown for each year, assuming that their consumption is based on their permanent income, rather than their current income.

As can be seen from the table, the individual’s consumption remains relatively stable over time, even as their income increases. This is because their consumption is based on their permanent income, which is assumed to increase gradually over time.

In 2018, the individual’s current income and permanent income are both $50,000, and their consumption is $45,000. In 2019, their income increases to $55,000, but their consumption only increases to $50,000, reflecting their desire to smooth their consumption over time.

In 2020, the individual’s income increases to $60,000, but their consumption only increases to $55,000. In 2021, their income increases to $70,000, but their consumption only increases to $60,000, reflecting the assumption that their permanent income has only increased to $65,000.

Finally, in 2022, the individual’s income increases to $80,000, but their consumption only increases to $65,000, reflecting the assumption that their permanent income has only increased to $70,000.

This example illustrates how the Permanent Income Hypothesis suggests that individuals base their consumption decisions on their long-term or “permanent” income, rather than their current income. By smoothing their consumption over time, individuals are able to maintain a stable standard of living, even as their income fluctuates.