Permanent income refers to a long-run measurement of average income, in which temporary fluctuations in income have minimal impact on consumption. This concept suggests that consumers base their consumption patterns more on their expectations of long-term average income rather than on short-term income variations.
Permanent Income Hypothesis (PIH)
Origin and Development
The Permanent Income Hypothesis (PIH) was introduced by economist Milton Friedman in 1957. According to PIH, an individual’s consumption at any given time is determined not by current income but by their anticipated average lifetime income, also known as permanent income.
Mathematical Representation
The PIH can be expressed mathematically as follows:
where:
- \( C_t \) is the consumption at time \( t \)
- \( \alpha \) is a constant marginal propensity to consume
- \( Y_t^P \) is the permanent income at time \( t \)
Types of Income According to PIH
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Permanent Income: Long-term, stable income that individuals expect to persist over time. Examples include salaries, long-term investment returns, and other predictable sources.
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Transitory Income: Temporary income that results from short-term fluctuations such as bonuses, lottery winnings, or temporary unemployment benefits.
Special Considerations
Consumption Smoothing
Consumers aim to “smooth” consumption over their lifetime. Instead of drastically altering consumption with every income change, they adjust their savings and borrowing to maintain a stable consumption pattern.
Applicability and Impact
Understanding the concept of permanent income helps explain why consumption patterns do not shift drastically with temporary changes in income. This insight is valuable for policymakers when designing economic stabilization policies, as it underscores the importance of influencing permanent income to achieve desired consumption outcomes.
Examples
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Salary Increase: An employee receives a temporary bonus. According to PIH, the employee will not significantly increase their consumption because they view the bonus as transitory.
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Winning the Lottery: A lottery winner is more likely to save the winnings or make one-time investments rather than change their consumption patterns dramatically.
Historical Context
Milton Friedman’s PIH revolutionized the field of macroeconomics by providing a robust explanation for consumer behavior, influencing subsequent research and policy design.
Comparisons and Related Terms
Life-Cycle Hypothesis (LCH)
The Life-Cycle Hypothesis, proposed by Franco Modigliani, also posits that consumers plan their consumption based on lifetime earnings but emphasizes different stages of life, such as accumulation during working years and decumulation during retirement.
Related Terms
- Marginal Propensity to Consume (MPC): The fraction of additional income that a household consumes rather than saves.
- Disposable Income: Income remaining after deductions of taxes and other mandatory charges.
FAQs
Q1: How does permanent income affect saving behavior?
A1: Individuals save more during periods of high transitory income and dissave during periods of low transitory income to maintain stable consumption.
Q2: Can permanent income change over time?
A2: Yes, permanent income can change due to shifts in long-term income expectations, career advancements, or significant economic shifts.
References
- Friedman, M. (1957). A Theory of the Consumption Function. Princeton University Press.
- Modigliani, F., & Brumberg, R. (1954). Utility Analysis and the Consumption Function: An Interpretation of Cross-section Data. In Post-Keynesian Economics.
Summary
Permanent income serves as a vital concept in economics, offering insights into consumer behavior and the underlying motivations behind consumption patterns. By differentiating between permanent and transitory income, the Permanent Income Hypothesis provides a framework for understanding how individuals manage financial resources throughout their lives.
