permanent income hypothesis

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permanent income hypothesis

the hypothesis that states that current CONSUMPTION is not dependent solely on current DISPOSABLE INCOME but also on whether or not that income is expected to be permanent or transitory. The permanent income hypothesis argues that both income and consumption are split into two parts, permanent and transitory. A person's permanent income comprises such things as their long-term earnings from employment (WAGES, SALARIES), retirement pensions and income derived from the possession of capital assets (INTEREST, DIVIDENDS). The amount of a person's permanent income will determine permanent consumption plans, for example, the size and quality of the house he or she will buy and thus long-term expenditure on mortgage repayments, etc.

Transitory income comprises short-term temporary overtime payments, bonuses and ‘windfall’ gains from winnings and inheritances, and short-term reductions in income arising from temporary unemployment and illness. Transitory consumption such as additional holidays, clothes, etc., will depend upon the amount of this extra income.

Long-term consumption may also be related to changes in a person's WEALTH, in particular the value of his or her house over time.

The economic significance of the permanent-income hypothesis is that in the short term the level of consumption may be higher (or lower) than that indicated by the level of current disposable income. See LIFE-CYCLE HYPOTHESIS, KEYNESIAN ECONOMICS, CONSUMPTION FUNCTION.

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