Permanent Income Hypothesis

Definition

The permanent income hypothesis (PIH) is an economic theory, formulated by Milton Friedman in 1957, that proposes people base their consumption on their expected long-term average income (their “permanent” income) rather than their current, short-term earnings. Temporary fluctuations in income—bonuses, one-time windfalls, or short-term pay cuts—have limited effect on long-term spending because individuals try to smooth consumption over time.

How it works

• Permanent income: an individual’s expected average income over a long horizon. Consumption plans are anchored to this expectation.
• Transitory income: temporary or unexpected changes in income. Most of these are saved or used to pay down debt rather than spent on lasting increases in consumption.
• Consumption smoothing: people use saving and borrowing to maintain relatively steady consumption in the face of income volatility.

Because consumption depends on expectations, short-lived policy measures that temporarily raise incomes (for example, one-off rebates) are less likely to generate large, sustained increases in consumer spending compared with measures that credibly raise people’s long-term income prospects.

Spending behavior under the PIH

• One-time gains (bonuses, inheritances) are often saved or invested rather than spent immediately, especially if recipients view them as transitory.
• Anticipated permanent increases (sustained raises, long-term job changes) lead to higher consumption because they raise expected lifetime resources.
• Expectations matter: if people revise upward their expectation of future income, they will adjust current spending accordingly.

Role of liquidity constraints

Liquidity—access to savings and borrowing—affects how closely actual behavior matches the PIH:
– Liquidity-constrained individuals may be forced to base consumption on current income, not permanent income.
– As people accumulate assets or secure more stable jobs, they become better able to smooth consumption in line with permanent-income expectations.

PIH vs. related concepts

• Life-cycle hypothesis: focuses on how saving and spending vary over a lifetime (e.g., young workers borrow, middle-age save, retirees draw down savings). It emphasizes age and lifecycle stages; PIH emphasizes expected long-run income at any point in life.
• Permanent vs. transitory income: permanent income is the stable expected average over time; transitory income is temporary, irregular, or unexpected.

Policy implications

• Temporary fiscal measures (short-term tax cuts, one-off stimulus checks) may have a muted effect on aggregate consumption if households view the income boost as transitory and save it.
• Policies that credibly raise long-term income expectations (sustained tax changes, structural reforms improving wages or employment prospects) are more likely to increase consumption and produce multiplier effects.

Key takeaways

• PIH argues consumption follows expected long-run income rather than current earnings.
• Temporary income changes tend to be saved; permanent changes prompt higher consumption.
• Liquidity constraints can limit the ability of some households to smooth consumption.
• Policy that changes long-term expectations is more effective at stimulating sustained consumption than temporary measures.

Bottom line

The permanent income hypothesis emphasizes expectations and consumption smoothing: people plan spending around a stable view of lifetime income. Understanding this helps explain why temporary income shocks often fail to produce large changes in aggregate spending and why credible, lasting improvements in income prospects are more likely to shift consumption behavior.