The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of the Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income (human capital, property, assets), rather than changes in temporary income (unexpected income), are what drive changes in consumption.

The formation of consumption patterns opposite to predictions was an outstanding problem faced by the Keynesian orthodoxy. Friedman's predictions of consumption smoothing, where people spread out transitory changes in income over time, departed from the traditional Keynesian emphasis on a higher marginal propensity to consume out of current income.

Income consists of a permanent (anticipated and planned) component and a transitory (unexpected and surprising) component. In the permanent income hypothesis model, the key determinant of consumption is an individual's lifetime income, not their current income. Unlike permanent income, transitory incomes are volatile.

Until A Theory of Consumption Function, the Keynesian absolute income hypothesis and interpretation of the consumption function were the most advanced and sophisticated. In its post-war synthesis, the Keynesian perspective was responsible for pioneering many innovations in recession management, economic history, and macroeconomics. Like the neoclassical school that preceded it, early inconsistencies had their roots in socio-political events contrary to the predictions put forward.

The introduction of the absolute income hypothesis is often attributed to John Maynard Keynes, a British economist, who wrote several books which are now the basis for Keynesian economics. The hypothesis put forward by Keynes was accepted and placed into the post–war synthesis. However, inconsistencies were not resolved swiftly, and economists were unable to explain the consistency of the savings rate in the face of rising real incomes (Fig. 1).

Before the neoclassical synthesis was established, Keynes and his hypothesis challenged the orthodoxy of neoclassical economics. As a result of the Great Depression, Keynes rapidly became among the leaders of economic thought. His MPC and MPS spending multipliers developed into the absolute income hypothesis (1), and were influential to the government responses to the ensuing depression.

The American economist Milton Friedman developed the permanent income hypothesis in his 1957 book A Theory of the Consumption Function. In his book, Friedman posits a theory that explained how and why future expectations change consumption.

Friedman's 1957 book A Theory of the Consumption Function created the basis for consumption smoothing. He argued the consumption model, in which outcomes are stochastic, where consumers face risks and uncertainty to their labor incomes, complicates interpretations of indifference curves, and causes consumers to spread out or 'smooth' their spending based on their permanent income, which represents their anticipated income over their lifetimes. Friedman explains this by how, for example, consumers would consistently save more when they expect their long-term income to increase. A further elaboration is provided below: