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Consumption and the Permanent Income Hypothesis | …
This paper investigates whether there are simple versions of the permanent income hypothesis which are consistent with the aggregate U.S. consumption and output data. Our analysis is conducted within the confines of a simple dynamic general equilibrium model of aggregate real output, investment, hours of work and consumption. We study the quantitative importance of two perturbations to the version of our model which predicts that observed consumption follows a random walk: (i) changing the production technology specification which rationalizes the random walk result, and (ii) replacing the assumption that agents' decision intervals coincide with the data sampling interval with the assumption that agents make decisions on a continuous time basis. We find substantially less evidence against the continuous time models than against their discrete time counterparts. In fact neither of the two continuous time models can be rejected at conventional significance levels. The continuous time models outperform their discrete time counterparts primarily because they explicitly account for the fact that the data used to test the models are tine averaged measures of the underlying unobserved point-in-time variables. The net result is that they are better able to accommodate the degree of serial correlation present in the first difference of observed per capita U.S. consumption.
The permanent income hypothesis (PIH) is a theory that links an individual’s consumption at any point in time to that individual’s total income earned over his or her lifetime. The hypothesis is based on two simple premises: (1) that individuals wish to equate their expected marginal utility of consumption across time and (2) that individuals are able to respond to income changes by saving and dis-saving. In this article we present the intuition and empirical implications of the PIH in several standard contexts.
income hypothesis, consumption depends primarily on permanent income
The theory that changes in consumption are unpredictable is based on the work of the
American economist Robert Hall. The theory is based on the Friedman's permanent income
hypothesis and the theory of rational expectations. According to Friedman's permanent
income hypothesis, consumption depends primarily on permanent income. At any moment in
their lifetime, consumers choose consumption based on their current expectations about
lifetime incomes. They would then change their consumption when they receive news that
causes them to change their expectations about their lifetime income. For example, a person
getting an unexpected promotion would revise his expectations about lifetime income
upwards and thus consume more. As long as consumers use all the available information to
assess their lifetime income, that is as long as they have rational expectations, then they
should only be surprised by events that were entirely unpredictable. Therefore, changes in
their consumption should be unpredictable as well.1 Hall (1978) tests this theory using
postwar aggregate US data and finds that past consumption data have no power in
predicting future consumption as he was unable to reject the hypothesis that lagged values
of either income or consumption can not predict the change in consumption. However,
lagged levels of the S&P stock market index help to predict future consumption.2 Hall's theory is based on several assumptions that he uses in testing the stochastic version
of lifecycle and permanent income hypotheses and which can be challenged. Firstly, there is
the simplifying assumption of a quadratic utility function, which implies that marginal utility is
linear in consumption. As a consequence, the individual consumption decision exhibits
certainty equivalence, which means that individuals ignore the variation of consumption and
act as if future consumption was as its conditional mean. Secondly, Hall further assumes that
consumer want to hold marginal utility and thus consumption constant over time.3 The
problem with the first assumption is that it is problematic to make predictions about individual
or aggregate utility functions. The second assumption may not be realistic since individuals
may on the one hand be aware of the fact that they can afford more consumption in their
working years than when they are still in education or retired and thus adjust their willingness
to smooth consumption. On the other hand, the Pull of Instant Gratification can assign a
higher marginal utility to consumption in the present than in the future, so individuals value
current consumption more than in future, which runs against assumption number two.
Thirdly, the assumption of rational expectations may also not hold for all individuals. When
Would it be correct to say that the Permanent Income Hypothesis (PIH) stipulates that current consumption decisions are made based on future income projections/expectations, while the Life Cycle Hypothesis (LCH) claims that consumption is constant over the average person's life time, and this is made possible, despite changes in income level throughout his/her lifetime, through borrowing when younger and savings during the elderly years?
Permanent income hypothesis consumption function by …
Permanent Income Change of Same Percentage 113
CHAPTER V: Consistency of the Permanent Income Hypothesis with Existing Evidence on the Relation between Consumption and Income: Time Series Data 115
Alternative Functions Fitted to Data for a Long Period 142
Appendix to Section 3: Effect on Multiple Correlation of Common Errors in Measured Consumption and Current Income 152
CHAPTER VI: The Relation Between the Permanent Income and Relative Income Hypotheses 157
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Permanent income hypothesis - Wikipedia
The Relation between Measured Consumption and Measured Income 31
CHAPTER IV: Consistency of the Permanent Income Hypothesis with Existing Evidence on the Relation between Consumption and Income: Budget Studies 38
Life-cycle hypothesis - Wikipedia
Like Duisenberg, Milton Friedman and Franco Modigliani argue that consumption function is essentially proportional, i.e., there is no tendency for the proportion of income saved to increase at higher income levels. They, however, believe that households do not adapt the their consumption behavior to their current income alone, but to a general level of their resource over extended period of time. This is called Permanent Income Hypothesis. Modiglianiâs theory of consumption, which is called Life Cycle Theory is similar to the permanent Income theory of Friedman.
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