What Is the Permanent Income Hypothesis?

The permanent income hypothesis is an economic theory that has to do with how consumers will structure their spending habits. The basis for the idea is that consumers will choose to arrange their spending on all types of goods and services based on their expectations for generating a certain average income over the long term. In the perception of the individual consumer, that projection of anticipated income becomes fixed or permanent as part of the way they perceive their spending power and also their ability to put aside a portion of their earnings for savings and other types of investments.

First propounded in 1957 by Milton Freidman, an economist who was also the recipient of a Nobel Prize, one of the hallmarks of the permanent income hypothesis is that prediction changes in consumer attitudes toward spending and saving can be difficult, since each consumer will respond to the same set of economic circumstances in different ways. While a given situation may prompt one consumer to cut back on spending and divert more income to savings, that same set of circumstances may motivate a different consumer to make more purchases in anticipation of not being able to afford those goods later on.

This focus on individuality in the permanent income hypothesis has relevance when it comes to the adoption of economic policies that can help to control the course of a national or even a local economy. Assuming that policies put in place by the government do help to reverse unfavorable economic trends and increase the flow of income in general, a portion of consumers will continue to save as if the crisis has not passed, possibly due to fear of a repeat of a period of recession occurring in the near future. Others will respond to the increased income within the economy by modestly increasing spending, and still others will resume spending at levels that are similar to more prosperous periods in the past.

Debates regarding the viability of the permanent income hypothesis continue. Proponents hold that the concept is grounded in data that demonstrates the nature of how consumers adjust spending habits based on their perceptions of their earning power. Detractors of the permanent income hypothesis tend to note that perceptions about economics factors, including spending and saving, are very different than in decades past, and that this particular approach may be less relevant to the way consumers view their income potential in today’s economic climate.