What is a 'Permanent Income Hypothesis'

The Permanent Income Hypothesis is 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.

How the Permanent Income Hypothesis Is Applied

For example, if a worker is aware they are likely to receive an income bonus at the end of a particular pay period, it is plausible that their spending in advance of that bonus may change in anticipation of the additional earnings. However, it is also possible that workers may choose to not increase their spending based solely on a short-term windfall. They may rather make efforts to increase their savings, based on the expected boost in income.

Something similar can be said of individuals who are informed they are to receive an inheritance; their personal expenditures could change to take advantage of the anticipated influx of funds but per this theory they may maintain their current spending levels in order to save the supplemental assets. Likewise they may seek to invest those supplemental funds in order to provide long-term growth of their money rather than spend it immediately on disposable products and services.

The liquidity of the individual can play a role in their future income expectations. An individual with no assets may already be in the habit of spending without regard to their income, current or future.

Changes over time, however, through incremental salary raises or the assumption of new long-term jobs that bring higher, sustained pay, can lead to changes in permanent income. With their expectations elevated, employees may allow their expenditures to scale up in turn.

RELATED TERMS
  1. Hypothesis Testing

    A process by which an analyst tests a statistical hypothesis. ...
  2. Null Hypothesis

    A null hypothesis is a type of hypothesis used in statistics ...
  3. Adaptive Expectations Hypothesis

    Adaptive expectations hypothesis is a theory that states individuals ...
  4. Income Effect

    The income effect is the change in demand for a good or service ...
  5. Type II Error

    A type II error is a statistical term used within the context ...
  6. Linder Hypothesis

    Linder Hypothesis posits that countries with similar per capita ...
Related Articles
  1. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  2. Managing Wealth

    How to Increase Your Disposable Income

    Here are four quick and easy ways to increase your spending money.
  3. Financial Advisor

    Tips For Getting A Permanent Visa

    Many countries can help you establish a path towards residency. Before you move, read this article first.
  4. Insurance

    Should You Buy Term or Permanent Life Insurance?

    When choosing between term or permanent life insurance you'll need to consider these factors.
  5. Investing

    Understanding the Income Statement

    The best way to analyze a company - and figure out if it's worth investing in - is to know how to dissect its income statement. Here's how to do it.
  6. Personal Finance

    How to Align Your Spending and Values

    Spending money is okay when it is aligned with what you value.
  7. Managing Wealth

    Who's Getting Richer? Hardly Anyone

    Federal 'economic gains' mask the truth: Most Americans are doing worse, with average incomes in 2014 smaller than in 2000. Call it upward redistribution.
  8. Insurance

    Cut Your Tax Bill With Permanent Life Insurance

    Learn how to lower your income tax and avoid estate tax - all while building wealth.
RELATED FAQS
  1. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  2. How Are Earnings And Income Different?

    Earnings is the profit a company has earned for a period. When investors refer to a company's earnings, they're typically ... Read Answer >>
Trading Center