Permanent Income Hypothesis | Theory and Definition

The permanent income hypothesis (PIH) is an economic theory which describe how agents spread consumption over their lifetimes. It was first developed by Milton Friedman, it assumes that a person's consumption at a point in time is determined not just by their current income but also by their expected income in future years which is known as their permanent income. Hence the permanent income hypothesis states the ongoing changes in permanent income, rather than
changes in temporary income. Because it is the permanent income that drive the changes in a consumer's consumption patterns Income consists of a permanent (anticipated and planned) component and a transitory (windfall gain/unexpected) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not his current income. Permanent income is defined as expected long-term average income. A consumer's permanent income is determined by their assets which both physical (shares, bonds, property) and human (education, knowledge and experience). These influence the consumer's ability to earn income. The consumer can then make an estimation of anticipated lifetime income. A worker saves only if they expect that their long-term average income, i.e. their permanent income, will be less than their current income.