permanentincome

The permanent income hypothesis is an economic theory developed by Milton Friedman that posits that an individual's consumption is based on their long-run average income, known as permanent income, rather than their current, or transitory, income. Transitory income refers to temporary fluctuations in income due to factors like unexpected bonuses, layoffs, or inheritances.

According to the hypothesis, individuals aim to smooth their consumption over time. They will spend a proportion of their permanent income and save or borrow to offset temporary deviations. For example, if someone experiences a temporary increase in income, they are likely to save a portion of it rather than significantly increasing their spending, anticipating that the higher income will not persist. Conversely, if their income temporarily falls, they might draw on savings or borrow to maintain their usual consumption levels.

The permanent income hypothesis has significant implications for understanding consumer behavior and the effectiveness of fiscal policy. It suggests that changes in income that are perceived as temporary will have a smaller impact on consumption than changes perceived as permanent. This has led to debates about how government policies, such as tax cuts, influence aggregate demand. If a tax cut is seen as temporary, individuals may save much of the extra income, leading to a muted response in consumption. If it is seen as permanent, the impact on consumption is expected to be larger. The theory is a cornerstone of modern macroeconomics and has been subject to extensive empirical testing and refinement.