Permanent Income Hypothesis
The Permanent Income Hypothesis (PIH) is an economic theory proposed by economist Milton Friedman. This hypothesis posits that consumers' consumption decisions are primarily based on their long-term expected income (permanent income) rather than current short-term income fluctuations. According to the PIH, consumers use savings and borrowing to smooth their consumption levels over time, making their consumption patterns more stable despite short-term income variations.
Key characteristics of the Permanent Income Hypothesis include:
Long-Term Perspective: Consumers' consumption decisions are based on their expectations of long-term income rather than short-term income changes.
Consumption Smoothing: Consumers try to maintain a stable level of consumption by saving during high-income periods and borrowing during low-income periods.
Savings and Borrowing: When income is high, consumers increase savings; when income is low, they borrow to maintain stable consumption levels.
Income Classification: Income is divided into permanent income (long-term sustainable income) and transitory income (short-term income fluctuations).
Example of the Permanent Income Hypothesis application:
Suppose an individual expects their long-term income (permanent income) to be $50,000 per year, but in a particular year, due to bonuses and other short-term factors, their income reaches $70,000. According to the PIH, the individual will not significantly increase their consumption but will save the additional $20,000 to use in future years when their income might fall below $50,000, thereby maintaining stable consumption.
Definition:
The Permanent Income Hypothesis (PIH) is an economic theory proposed by economist Milton Friedman. It posits that consumers' consumption decisions are primarily based on their long-term expected income (i.e., permanent income) rather than current short-term income fluctuations. According to the PIH, consumers smooth their consumption levels through saving and borrowing to cope with short-term income changes, resulting in more stable consumption patterns.
Origin:
The Permanent Income Hypothesis was introduced by Milton Friedman in 1957 as a supplement and correction to Keynesian consumption theory. Friedman argued that Keynesian theory overly focused on current income, neglecting the impact of consumers' expectations of future income on their consumption behavior.
Categories and Characteristics:
1. Long-term Perspective: Consumers' consumption decisions are based on their long-term income expectations rather than current income fluctuations.
2. Consumption Smoothing: Consumers use saving or borrowing to maintain a stable consumption level, even when short-term income fluctuates.
3. Saving and Borrowing: Consumers increase savings when income is high and borrow when income is low to maintain stable consumption.
4. Income Classification: Income is divided into permanent income and transitory income, with permanent income referring to long-term sustainable income levels and transitory income referring to short-term income fluctuations.
Specific Cases:
1. Case One: Suppose an individual expects their long-term income (permanent income) to be $50,000 per year, but in one year, due to bonuses and other short-term factors, their income reaches $70,000. According to the PIH, the individual will not significantly increase consumption but will save the extra $20,000 to use in future years when income might fall below $50,000, thus maintaining stable consumption.
2. Case Two: A freelancer with highly variable income expects an average annual income of $60,000. In high-income years, they save the excess income, and in low-income years, they use savings or borrow to maintain stable consumption levels.
Common Questions:
1. Q: Does the Permanent Income Hypothesis apply to all consumers?
A: Not all consumers can fully adhere to the PIH, especially those with unstable incomes or lacking access to saving and borrowing mechanisms.
2. Q: How do you distinguish between permanent and transitory income?
A: Permanent income refers to long-term sustainable income levels, while transitory income refers to short-term income fluctuations. Consumers typically distinguish between the two based on their expectations of future income.
