Permanent income hypothesis is a theory of consumption by Milton Friedman, who belongs to free- market camp of the Chicago school of economics. He created this theory to answer the problems that rose from the Keynesian constant of consumption and marginal propensity to consume.
Keynes said that consumers react to even a temporary rise and fall in their income this was not found out to be true as the income rose for a short span the demand rises but after a point this rise stops and the demand becomes constant. In layman’s terms the low income groups boosted the demand when cash in hand increases but high income groups do not boost even with more input of cash in the economy
To solve this problem Friedman in his book A Theory Of Consumption said that people react to change only in their permanent income which is actually the average of the total income assumed to be earned by an individual. He says that people save more when they think that their income may decrease and spend more when their income may rise example an expectation of a promotion encourages more spending as deficit of today will be balanced by the surplus of tomorrow.
This was proved by Robert Hall and Friedrich Mishkin in 1978 where they analyzed Consumption of past income, that proved the theory with 80% of 2000 households sampled. The critics of the theory say that the hypothesis is part of a larger Keynesian framework where it explains the not so important long-term, while Keynes can only explain the short term.
Current Situation: the theory is important for the government as it proves that the temporary cut in tax will not increase the private consumption as many governments assume. This is proved by Shapiro and Slemrod (2003) where many defects in original theory were found, like the lack of inclusion of behavioral economics and the lack of facilities for borrowing and savings. This has being improved by adding new exceptions and conditions like buffer stock.
By Aviraj Singh Mehta
Image Source: The Economics Discussion
