Permanent Income Hypothesis

The consumption function puzzle

Keynes (1936) held that consumption depends on current disposable income and that the average propensity to consume, the share of income spent, falls as income rises. Short-run household data supported this, but Simon Kuznets's (1946) long-run US data from 1869 showed the average propensity to consume nearly constant at about 0.9 even as income multiplied. To resolve this consumption function puzzle, Modigliani and Brumberg (1954) proposed the life-cycle hypothesis and Milton Friedman (1957) the permanent income hypothesis. Because both hold that consumers smooth spending by considering future as well as current income, they are grouped together as forward-looking theories of consumption.

Core ideas

Friedman divided measured income Y into permanent income Yᵖ and transitory income Yᵗ. Permanent income is the long-run average expected from a person's abilities, education and wealth; transitory income consists of unexpected fluctuations such as lottery wins, one-off bonuses or temporary unemployment. Consumption is proportional to permanent income, C = kYᵖ, and transitory income is mostly saved. This resolves the puzzle. In a cross-section at one point in time, high-income households include many with temporarily high income, so the average propensity to consume appears low; in long time series, income growth is mostly permanent, so the consumption ratio stays constant. Friedman estimated permanent income as a weighted average of past income, an adaptive approach later replaced by rational expectations. The policy implication is that temporary tax cuts or transfers do little to raise consumption.

Tests and extensions

Robert Hall (1978) combined the hypothesis with rational expectations and showed that, if it holds, consumption should follow a random walk whose changes cannot be predicted by available information. Flavin (1981) and Campbell and Mankiw (1989), however, found excess sensitivity, with consumption responding to predictable income changes; Campbell and Mankiw estimated that about half of the population simply spends current income. Zeldes (1989) pointed to liquidity constraints as a cause, and Carroll (1997) modeled buffer-stock saving driven by income uncertainty. Parker et al. (2013) showed that about 12–30 percent of the 2008 US stimulus payments were spent on nondurables within three months, confirming that transitory income is substantially consumed. Kaplan and Violante (2014) attributed such responses to "wealthy hand-to-mouth" households with ample illiquid assets such as housing but little cash.

FAQ

What is the permanent income hypothesis in simple terms?

People spend according to the average income they expect to earn steadily over time, not this month's paycheck, and save most one-off windfalls such as bonuses.

How does it differ from the life-cycle hypothesis?

Both say people smooth consumption using future income, but the life-cycle hypothesis stresses saving across life stages such as retirement, while the permanent income hypothesis stresses the split between permanent and transitory income.

Sources reviewed: 2026-10-26

References

1. Friedman, M. (1957). A Theory of the Consumption Function. Princeton: Princeton University Press.
2. Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Macmillan.
3. Kuznets, S. (1946). National Product since 1869. New York: National Bureau of Economic Research.
4. Modigliani, F., & Brumberg, R. (1954). Utility analysis and the consumption function. In K. K. Kurihara (Ed.), Post-Keynesian Economics (pp. 388–436). New Brunswick: Rutgers University Press.
5. Hall, R. E. (1978). Stochastic implications of the life cycle–permanent income hypothesis. Journal of Political Economy, 86(6), 971–987.
6. Flavin, M. A. (1981). The adjustment of consumption to changing expectations about future income. Journal of Political Economy, 89(5), 974–1009.
7. Campbell, J. Y., & Mankiw, N. G. (1989). Consumption, income, and interest rates. NBER Macroeconomics Annual, 4, 185–216.
8. Deaton, A. (1992). Understanding Consumption. Oxford: Clarendon Press.
9. Carroll, C. D. (1997). Buffer-stock saving and the life cycle/permanent income hypothesis. Quarterly Journal of Economics, 112(1), 1–55.
10. Zeldes, S. P. (1989). Consumption and liquidity constraints. Journal of Political Economy, 97(2), 305–346.
11. Parker, J. A., Souleles, N. S., Johnson, D. S., & McClelland, R. (2013). Consumer spending and the economic stimulus payments of 2008. American Economic Review, 103(6), 2530–2553.
12. Kaplan, G., & Violante, G. L. (2014). A model of the consumption response to fiscal stimulus payments. Econometrica, 82(4), 1199–1239.
13. Jappelli, T., & Pistaferri, L. (2010). The consumption response to income changes. Annual Review of Economics, 2, 479–506.