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.