Milton Friedman’s Permanent Income Hypothesis

Milton Friedman’s Permanent Income Hypothesis

Like Modigliani, Friedman argued that consumption is related
not to current income but to a longer term estimate of income,
which Friedman terms as “permanent income”. But the PIH is
different from the LCH in that while income follows a regular
pattern over a person’s lifetime in the LCH, the PIH
emphasizes that people experience temporary and random
changes in their income year after year.

Friedman argued that a person’s current income (Y) can be
decomposed into two parts (i) permanent income (Yp) and (ii)
transitory income (Yt). Yp is the income that people expect to
persist into their future (long term income). Yt is unexpected
income/windfall.

Although income fluctuates, people generally rather have a
constant standard of living though time. For people to avoid
fluctuations in their consumption, Friedman argued that
consumption should mainly depend on Yp rather than Yt
because in the latter people will have to borrow and save to
smooth their consumption over time.