Permanent Income Hypothesis
The permanent income hypothesis (PIH) is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, the hypothesis states that the choices made by consumers regarding their consumption patterns are largely determined by a change in permanent income, rather than change in temporary income. The key conclusion of this theory is that transitory, temporary changes in income have little effect on consumer spending behavior, whereas permanent changes can have large effects on consumer spending behavior.
Measured income and measured consumption contain a permanent (anticipated and planned) element and a transitory (windfall gain/unexpected) element. Friedman concluded that the individual will consume a constant proportion of his/her permanent income; and that low income earners have a higher propensity to consume; and high income earners have a higher transitory element to their income and a lower than average propensity to consume.
In Friedman's permanent income hypothesis model, the key determinant of consumption is an individual's real wealth, not his current real disposable income. Permanent income is determined by a consumer's assets; both physical (shares, bonds, property) and human (education and experience). These influence the consumer's ability to earn income. The consumer can then make an estimation of anticipated lifetime income.
Transitory income is the difference between the measured income and the permanent income. It can be calculated simply by subtracting the measured income and the permanent income.
There is a corollary to the permanent income hypothesis named the permanent production hypothesis. This hypothesis stipulates that the choices made by producers regarding their production patterns are determined not by their present term capital cost but by their longer-term capital cost expectations. The key conclusion of this theory is that transitory, short term changes in capital costs have little effect on production behavior.
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