Permanent Income
Categories: Econ
Win the lottery. Tap into a trust fund. Inherit the throne of some obscure but enormously wealthy country. Achieve tenure at some prestigious university...or maybe just get elected to the U.S. Senate. Those situations cover one concept of permanent income. Income that will be coming in forever, no matter what you do.
In economics, though, the concept is more particular. It's used to explain consumer spending patterns. Called the permanent income hypothesis, the model assumes that a person will spend money according to what they think their long-term average income will be. In other words, people get an idea in their head about how much they're likely to make going forward. Like...into the distant future. And that expectation drives their spending activity.
You’re an economist. We know...dare to dream. But you’re not just a run-of-the-mill, on-one-hand-and-on-the-other-hand type of economist. You are a very confident economist. Brash. Brazen. Impertinent. You just graduated last in your class from Jacksonville Online Economic Technical Institute and Culinary Academy. Still, you are 100%, without a doubt, definitely convinced that you will one day win the Nobel Prize in economics.
The Nobel Prize includes a cash award of around $900,000, depending on the year and Swedish currency exchange rates. You are positive you're going to win that someday. So, by permanent income theory, you count that in your permanent income. You’re 23 now, fresh out of Jack Econ Tech And Culinary...average lifespan is about 79 years. That gives you about 56 years to go.
Divide $900,000 by 56. That’s $16,071.43 extra that you can spend each year. You’ll have to borrow the money for now...at least until you get the call from Sweden.
Another example. You work at a factory that makes leashes and collars for pet ducks. You make $50,000 a year as a quality control inspector in the R&D department. You spend your days out back by the scientifically designed, man-made lake, leading ducks with experimental leashes.
You assume you'll keep this basic salary for the foreseeable future. Under the permanent income hypothesis, your assumed "permanent income" is $50,000. You'll spend up to that level. Now...you get some weird news. Your eccentric uncle decides he wants to give away his worldly belongings and move to a Buddhist commune in Mongolia. Your share: $5,000.
So this particular year, you brought in $55,000. You got your usual $50,000 for your job at the duck leash factory, and an additional, one-time bonus amount of $5,000 from your uncle.
Someone supporting the permanent income hypothesis would expect you to save the $5,000 from your uncle. You know the $5,000 is a one-time bonus. Your uncle has moved to the Buddhist commune and doesn't have any more money to give away. You don't have any other uncles.
Point is: the $5,000 gift is not likely to repeat. Your perception of your long-term "permanent income" hasn't changed. You still expect to earn $50,000 a year long-term. So you sock the $5,000 away for a rainy day. Next year, you get a promotion. You are now head of the duck collar quality control department. Your salary rises to $85,000. Your expectations rise as well.
You assume you'll be head of the department for the foreseeable future. You don't save the additional $35,000 in salary. You're happy to spend it. You trade in your Yaris for a Cadillac, and you skip the $5 wine rack for stuff in the $20 aisle.
Your new assumed permanent income has changed. Now you perceive $85,000 as your permanent income...so you spend accordingly. You buy a diamond collar for your own pet duck. Maybe a little extravagant, even for $85,000 a year. But you did get to use your employee discount.
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And finance Allah shmoop What is permanent income Oh win
the lottery tap into a trust fund inherit the throne
of some obscure but enormously wealthy country achieved tenure at
some prestigious university Or maybe just get elected to the
U S Senate Those situations cover one concept of a
permanent income income that will be coming in forever no
matter what you do In economics though the concept is
more particular It's used to explain consumer spending patterns called
the permanent income hypothesis The model assumes that a person
will spend money according to what they think they're long
term Average income will be In other words people get
an idea in their head about how much they're likely
to make going forward like off into the way distant
future And that expectation then drives their spending activity So
you're an economist we know dare to dream But you're
not just a run of the mill On the one
hand and on the other hand type of economists you're
a very confident economist Brash brazen impertinence You just graduated
last in your class from Jacksonville Online Economic Technical Institute
and Culinary Academy I'll steal You are one hundred percent
without a doubt Definitely convinced you're one day going to
win that million dollar Nobel Prize in economics You're positive
you're gonna win that dough someday Yeah So by permanent
income theory you count that number in your permanent income
Well you're twenty three now fresh out of Jackie Con
tech and cool average life spans about seventy nine years
That gives you about fifty six years to go divide
a million bucks by fifty six And that's Ah seventeen
grand dish extra that you Khun spend each year Well
you'll have to borrow the money for now at least
until you get a call from Sweden Another example You
work in a factory that makes leashes and collars They're
for pet ducks You make fifty grand a year Is
a quality control inspector in the RND department You spend
your days out back by the scientifically designed man made
lake leading ducks along with the experimental leashes You assume
you'll keep this basic salary for the foreseeable future Well
under the permanent income hypothesis is you've assumed a permanent
income is fifty grand You'll spend up to that level
but not beyond that level Now you get some weird
news You're eccentric Uncle decides he wants to give away
his worldly belongings and move to a Buddhist commune in
Mongolia Your share Five grand Okay so this particular year
you brought in fifty five thousand right You've got your
usual fifty grand for your job the ducklings factory and
an additional one time bonus amount of five grand from
your uncle Well someone supporting the permanent income hypothesis would
expect you to save the five grand from your uncle
You know the five thousand dollars a one time bonus
Your uncle has moved to the Buddhist com unit Doesn't
have any more money to give away You don't have
any other sickly or weird uncles Point is the five
grand gift is not likely to repeat your perception of
your long term permanent income has not changed You still
expect to earn fifty grand a year long term So
you socked away the five grand you know for a
rainy day Okay well then next year comes along and
you get a promotion You're now head of the duck
collar quality control department Your salary rises to eighty five
thousand dollars and your expectations rise as well You assume
you'll be head of the department or better forever least
for the foreseeable future You don't say the additional thirty
five grand in salary You're happy to spend it You
trade in your Yaris that thing or Prius Maybe for
a Cadillac and you skipped the five dollar wine rack
for stuff in the twenty dollar I'll your new assumed
permanent income has changed Now you perceive eighty five thousand
dollars as your permanent income or income level so you
spend it accordingly Then you buy a diamond collar for
your own pet duck Yeah maybe a little extravagant even
for an eighty five thousand dollars a year employee But
well you did get to use your employee discount so 00:03:50.93 --> [endTime] you know it's a bargain