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The permanent income hypothesis was developed by the American economist Milton Friedman. In its simplest form, the permanent income hypothesis states that the choices consumers make regarding their consumption patterns are determined not by current income but by their longer-term income expectations. Measured income and measured consumption contain a permanent (anticipated and planned) and a transitory (windfall/unexpected) . 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 to their income and a lower than average propensity to consume. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their "normal" income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly. In order to test the theory, Friedman assumed that on the average people would base their idea of normal or permanent income on what had happened over the past several years. Thus, if they computed permanent income as the average of the past four years, and income had been $13,000, $10,000, $15,000, and $8,000, they would consider their permanent income as $11,500.1 Although our expectations of future income do not depend solely on what has happened in the past, these additional factors are almost impossible to include into attempts to test the theory with data. Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it have a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average. The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. 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. The theory suggests that consumers try to smooth out consumer spending based on their estimates of permanent income. Only if there has been a change in permanent income will there be a change in consumption. The key conclusion of this theory is that transitory changes in income do not affect long run consumer spending behaviour. Suppose a government cuts taxes prior to a general election. If consumers perceive this to be only a temporary reduction in their tax burden to increase the government's popularity, then consumption will remain unchanged. If the tax cut is seen as permanent then this may cause increased spending.
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