Reviewed by Sep 30, 2020| Updated on
The theory of the permanent income hypothesis deals with consumer spending. As per the theory, consumers will spend in accordance with their long term average income. The expected long term average income is a permanent income.
The theory of the permanent income hypothesis was created by economist, Milton Friedman, in 1957. The theory says that consumer behaviour is based on individual preferences and hence unpredictable. Consumer behaviour is an important factor for determining overall economic policy.
The theory also states that even if economic policies are able to increase the income in the economy, they may not result in a multiplier effect in the economy from incremental consumer spending. Consumer spending may not gather momentum until workers are optimistic about their future incomes.
However, it is subjective as to how an individual would spend the incremental income. For example, an individual who expects a bonus at the end of a particular year may either advance their spending or may plough the additional income into savings.
Thus, an individual may increase their expenditure on consumer goods and services or may invest the additional funds into long term growth options. In either of the cases, it is the present liquidity and expectation of future permanent income that is likely to influence the decision of spending the money on consumer goods or services or investing the money for long term growth.
A consumer behaviour similar to above can also be seen in the case of individuals who receive inheritances. They may spend the money or save and invest the windfall for their future.
The changes that occur over a period of time, such as incremental salary raise, or movement into long term employment which bring an incremental and sustained paycheck can lead to changes in permanent income. Thus, with an increase in permanent income, employees may shore up their consumption and increase their expenditures.