Consumption Based on Long-Term Income Expectations: The Permanent Income Hypothesis
The Permanent Income Hypothesis, proposed by Milton Friedman, suggests that consumption choices are guided by individuals’ perceptions of their long-term income prospects, termed permanent income. The theory distinguishes between permanent income (the stable, anticipated income stream over an individual’s lifetime) and transitory income (temporary fluctuations in income due to unexpected events or cyclical changes).
The sources define permanent income as “the amount a consumer unit could consume (or believes that it could) while maintaining its wealth intact.” It factors in not just current income but also the individual’s assets, skills, and economic prospects.
The hypothesis asserts that permanent consumption, the planned level of spending consistent with permanent income, is proportional to permanent income. This proportionality is represented by a coefficient ‘k’ that reflects factors like interest rates, the ratio of property income to wealth, and the individual’s inherent propensity to consume.
The sources posit that transitory income does not significantly influence consumption decisions. Individuals adjust their savings to accommodate temporary income fluctuations, smoothing their consumption patterns over time.
This framework offers a solution to the “consumption puzzle” - the discrepancy between the short-run and long-run consumption function. In the short run, where measured income includes both permanent and transitory components, the consumption function appears non-proportional. However, over the long run, as transitory income effects average out, the relationship between consumption and permanent income becomes proportional.
The sources offer a visual representation of this concept, with a long-run consumption function (CL) depicting the proportional relationship between permanent income and consumption, and a short-run consumption function (CS) showcasing the non-proportional relationship due to the influence of transitory income components.
However, the sources also present criticisms of the Permanent Income Hypothesis:
- The assumption of zero correlation between transitory income and consumption is challenged as unrealistic. Individuals might adjust consumption based on unexpected income changes, contrary to the theory’s prediction.
- The theory’s assertion that the APC remains the same for all income groups in the long run is contested. Empirical observations suggest that lower-income households tend to have a higher APC compared to higher-income households.
Despite these criticisms, the Permanent Income Hypothesis emphasizes the importance of long-term income expectations in shaping consumption decisions. It provides a valuable framework for understanding how individuals attempt to smooth their consumption patterns over time, even in the face of income fluctuations.