- Person
- Milton Friedman
- Lived
- 1912–2006
- Field
- Economics
- From
- American
The story
How do families decide how much to spend and how much to save? In the years after the Second World War the dominant answer came from John Maynard Keynes, who had suggested that people adjust their spending mainly to their current income. That idea underpinned the belief that governments could reliably steer the economy by changing taxes and spending. Milton Friedman thought the picture was more subtle.
Two early jobs gave him the raw material. In 1935 he helped design a large consumer budget study for the federal government in New Deal Washington, and from 1937 he assisted Simon Kuznets at the National Bureau of Economic Research in a study of professional incomes. Their joint book, Incomes from Independent Professional Practice, introduced the ideas of permanent and transitory income. Friedman later said the pieces came together during fireside conversations at his summer cottage in New Hampshire with his wife Rose and their friends Dorothy Brady and Margaret Reid, all of whom were working on consumption.
The result, A Theory of the Consumption Function, was published by Princeton University Press in 1957. It argued that a household's income has two parts: a permanent part, roughly the average it expects to earn over several years, and a transitory part made up of temporary ups and downs. People base their spending on the permanent part, so they tend to smooth their consumption over time, and unexpected windfalls are mostly saved.
The idea explained puzzles in the data that the simple Keynesian theory could not, and it carried a lesson for policy: temporary changes in income, such as a one-off tax rebate, should move spending less than the simple theory predicted. Friedman himself called it his best scientific work. When the Royal Swedish Academy of Sciences gave him the Nobel Prize in 1976, it described his re-fashioning of the theory of consumption as of primary importance among his achievements.
The hypothesis later became part of mainstream economics. Robert Hall recast it in a rational expectations model, and Christopher Carroll and others extended it to allow for people who cannot borrow freely. Economists still use the distinction between permanent and transitory income when they study how families respond to job losses, bonuses and changes in taxes, and when governments weigh whether a one-off payment will boost spending or simply be saved.
Why it matters
The permanent income hypothesis remains a central idea in how economists study household spending and saving.
About Milton Friedman
Chicago economist and 1976 Nobel laureate whose monetarism and free-market advocacy reshaped central banking, ended the US draft and influenced governments worldwide.
More about Milton Friedman
- Milton Friedman made the case for floating exchange ratesMilton Friedman's 1953 essay The Case for Flexible Exchange Rates argued for floating currencies at a time when most experts thought the idea unrealistic.
- Milton Friedman showed what caused the Great DepressionIn their 1963 Monetary History of the United States, Milton Friedman and Anna Schwartz argued that a collapse in the money supply turned a downturn into the Great Depression.
- Milton Friedman foresaw the problem of stagflationIn 1968 Milton Friedman argued that inflation cannot permanently reduce unemployment, a theory that anticipated the stagflation of the 1970s.
- Milton Friedman helped invent sequential samplingDuring the Second World War, Milton Friedman and colleagues at Columbia developed sequential sampling, which became the standard method of quality control inspection.
Sources
- Milton Friedman Wikipedia
- Milton Friedman: Biographical NobelPrize.org
- Permanent income hypothesis Wikipedia
- Press release: The Prize in Economic Sciences 1976 NobelPrize.org
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