The permanent income hypothesis (PIH) was developed by Nobel Prize winner Milton Friedman in 1957. Friedman posited that the consumer's behavior is primarily motivated by long-term income expectations, rather than short-term spending needs. According to the PIH, consumer spending is related not only to current income but also to an individual's expected long-term average income. The theory asserts that even if there is a temporary increase in income, individuals will not make proportionally more spending decisions, as temporary income changes aren’t always associated with permanent income changes.

Under the Permanent Income Hypothesis, consumers calculate their planned expenditure based on their long-term average income, which Friedman referred to as “permanent income”. This encourages individuals to save and invest some of the money they earn. The PIH serves as an important framework for understanding consumer behavior, as it places a greater emphasis on the concept of long term financial stability than short term goals or impulses.

The PIH also suggests that consumer spending depends heavily on the liquidity of an individual’s income. If an individual has a windfall, they may choose to save or invest the money instead of spending it unless they feel they will have access to enough long-term income to support future consumption decisions. This is especially important to consider when making adjustments to the budget due to an increase or decrease in income.

The Permanent Income Hypothesis has been widely accepted by economic theorists as it takes into account both income and liquidity when examining consumer behavior. The concept remains a key point of reference for economists and policy makers when assessing consumer spending trends in relation to fiscal and monetary policies. Additionally, the theory provides consumers with an understanding of how to most effectively manage their income and spending in order to ensure long-term financial stability.