Permanent income hypothesis (PIH) is the theory of consumption. In his theory, John Maynard Keynes supported economic policy makers by his argument emphasizing their capability of macroeconomic fine-tuning. The only problem was that actual consumption time series were much less volatile than the predictions derived from the theory of Keynes. For Keynes, consumption expenditures are linked to disposable income by a parameter called marginal propensity to consume. However, since marginal propensity to consume itself is a function of income, it is also true that additional increases in disposable income lead to diminishing increases in consumption expenditures: in other words, marginal propensity to consume is in a reverse relation with real income. It must be stressed that the relation characterized by substantial stability links current consumption expenditures to current disposable income–and, on these grounds, a considerable leeway is provided for aggregate demand stimulation, since a change in income immediately results in a multiplied shift in aggregate demand. This is the essence of the Keynesian case of the multiplier effect. The same is true of tax cut policies, of course. According to the basic theory of Keynes, governments are always capable of countercyclical fine-tuning of macroeconomic systems through demand management.
Permanent income hypothesis questions this ability of governments. However, it is also true that permanent income theory is concentrated mainly on long-run dynamics and relations, while Keynes focused primarily on short-run considerations. The emergence of the PIH raised serious debates, and the authors tried either to verify or to falsify the theory of Friedman–in the latter case, arguments were directed mainly towards stressing that the relation between consumption and disposable income still follows (more or less) the mechanism supposed by Keynes. According to some hints dropped in the literature, PIH has the advantage (among others) that it can help us resolve the (alleged) inconsistency between occasionally arising large-scale fluctuations of disposable income and the considerable stability of consumption expenditures.
Friedman starts elaborating his theory under the assumption of complete certainty. Under these conditions, a consumer unit precisely knows each definite sum it will receive in each of a finite number of periods and knows in advance the consumer prices plus the deposit and the borrowing rates of interest that will prevail in each period. Under such circumstances, for Friedman, there are only two motives for a consumer unit to spend more or less on consumption than its income: The one is to smooth its consumption expenditures through appropriate timing of borrowing and lending; and the second is either to realize interest earnings on deposits if the relevant rate of interest is positive, or to benefit from borrowing if the interest rate is negative. The concrete behaviour of a consumer unit under the joint influence of these factors depends on its tastes and preferences.
According to PIH, the distribution of consumption across consecutive periods is the result of an optimizing method by which each consumer tries to maximize his utility. At the same time, whatever ratio of income one devotes to consumption in each period, all these consumption expenditures are allocated in the course of an optimization process–that is, consumer units try to optimize not only across periods but within each period.
We have a fundamentally different framework if expectations are rational (REH). Under these circumstances not only some past but also all information as for the future available at the moment is utilized in forming expectations about permanent income. To revise the level of consumption expenditures it is not enough to realize the changes in current income, since if this shift could be foreseen, rationally expecting agents built this development into their expectations in advance. It has to be mentioned that consumption follows a random walk path under REH.