Permanent Income Hypothesis

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Definition of 'Permanent Income Hypothesis'

The permanent income hypothesis (PIH) is a theory in economics that states that consumption is determined by a household's long-run expected income, rather than by its current income. The hypothesis was first proposed by Milton Friedman in his 1957 book, A Theory of the Consumption Function.

The PIH is based on the idea that consumers have rational expectations about their future income and that they use these expectations to make consumption decisions. In other words, consumers do not base their consumption on their current income, which can be volatile, but rather on their long-run expected income, which is more stable.

The PIH has a number of implications for economic policy. For example, the hypothesis suggests that government policies that affect current income, such as tax cuts or government spending, will have little effect on consumption. This is because consumers will offset the effects of these policies by saving or dissaving, so that their long-run expected income remains unchanged.

The PIH has also been used to explain a number of empirical observations about consumption. For example, the hypothesis can explain why consumption tends to be relatively stable over time, even in the face of large changes in current income. The hypothesis can also explain why consumption tends to be higher in countries with more stable economic growth.

The PIH is a controversial theory, and there is some evidence that it does not always hold in practice. However, the hypothesis remains an important contribution to the understanding of consumer behavior.

In addition to the implications for economic policy, the PIH has also been used to explain a number of other economic phenomena. For example, the hypothesis has been used to explain why stock market crashes do not lead to a decline in consumption. The hypothesis can also explain why consumers are willing to pay a premium for life insurance.

The PIH is a complex theory, and there is still much that we do not know about it. However, the hypothesis has provided important insights into consumer behavior and has had a significant impact on the field of economics.

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