Permanent Income Hypothesis

DEFINITION of 'Permanent Income Hypothesis'

A theory of consumer spending which states that people will spend money at a level consistent with their expected long term average income. The level of expected long term income then becomes thought of as the level of "permanent" income that can be safely spent. A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.

BREAKING DOWN 'Permanent Income Hypothesis'

The permanent income hypothesis was formulated by the Nobel Prize winning economist Milton Friedman in 1957. The hypothesis implies that changes in consumption behavior are not predictable, because they are based on individual expectations. This has broad implications concerning economic policy. Under this theory, even if economic policies are successful in increasing income in the economy, the policies may not kick off a multiplier effect from increased consumer spending. Rather, the theory predicts there will not be an uptick in consumer spending until workers reform expectations about their future incomes.

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