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Friedman's P.I.H.


In Friedman's permanent income hypothesis model, the key determinant of consumption is an individual's real wealth, not his current real disposable income. Permanent income is determined by a consumer's assets; both physical (shares, bonds, property) and human (education and experience). These influence the consumer's ability to earn income. The consumer can then make an estimation of anticipated lifetime income.


The theory suggests that consumers try to smooth out consumer spending based on their estimates of permanent income. Only if there has been a change in permanent income will there be a change in consumption.


The key conclusion of this theory is that transitory changes in income do not affect long run consumer spending behaviour.


Suppose a government cuts taxes prior to a general election. If consumers perceive this to be only a temporary reduction in their tax burden to increase the government's popularity, then consumption will remain unchanged. If the tax cut is seen as permanent then this may cause increased spending.




E-mail Steve Margetts