Iowa State University Capstones, Theses and Retrospective Theses and Dissertations Dissertations 1994 Permanent income hypothesis and the cost of adjustment Gerald F. Parise Iowa State University Follow this and additional works at: https://lib.dr.iastate.edu/rtd Part of the Economic Theory Commons Recommended Citation Parise, Gerald F., "Permanent income hypothesis and the cost of adjustment " (1994). Retrospective Theses and Dissertations. 11304. https://lib.dr.iastate.edu/rtd/11304 This Dissertation is brought to you for free and open access by the Iowa State University Capstones, Theses and Dissertations at Iowa State University Digital Repository. It has been accepted for inclusion in Retrospective Theses and Dissertations by an authorized administrator of Iowa State University Digital Repository. For more information, please contact [email protected]. INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. 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Photogrs^hs included in the original manuscript have been reproduced xerographically in this copy. Higher quality 6" x 9" black and white photographic prints are available for ai^ photographs or illustrations appearing in this copy for an additional charge. Contaa UMI directly to order. A Bell & Howell information Company 300 North Zeeb Road. Ann Arbor. Ml 48106-1346 USA 313.'761-4700 800/521-0600 Order Number 9518427 Permanent income hypothesis and the cost of adjustment Parise, Gerald Francis, Ph.D. Iowa State University, 1994 UMI 300N.ZeebRd. Ann Arbor, MI 48106 Permanent income hypothesis and the cost of adjustment by Gerald F. Parise A Dissertation Submitted to the Graduate Faculty in Partial Fulfillment of the Requirements for the Degree of DOCTOR OF PHILOSOPHY Department: Economics Major; Economics Approved: Signature was redacted for privacy. Signature was redacted for privacy. Forfthe Major Department Signature was redacted for privacy. Fp^e Graduate College Iowa State University Ames, Iowa 1994 II TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1 CHAPTER 2: PERMANENT FNCOME HYPOTHESIS 9 CHAPTER 3: DATA 42 CHAPTER 4: COSTLY ADJUSTMENT 73 CHAPTER 5: LEARNING 138 CHAPTER 6: CONCLUSION 205 BIBLIOGRAPHY 215 APPENDIX A 221 APPENDIX B 224 APPENDIX C 227 APPENDIX D 230 ACKNOWLEDGMENTS 232 1 CHAPTER 1: INTRODUCTION Consumption, which accounts for more than 60 percent of the U.S. gross national product, is an area of macroeconomics that has always received much attention. Understanding this important sector would offer greater insights into the evolution and direction of the economy in general. All this attention, however, has not always translated into greater understanding. Despite the development of numerous models and prodigious study, the field of consumption theory remains very much open. From the 1950s to today, consumption theory has seemed intent on shaking off the naivete commonly associated with the Keynesian view of consumption. Contrary to the Keynesian view, where consumption is simply a function of current income, theory would be based on an optimization framework where rational agents would attempt to maximize utility. Being rational, agents would formulate a lifetime consumption path subject to the constraint impo.sed by total lifetime resources. Current income would not be a good predictor of current consumption because such a limited notion of income forms but a small part of total lifetime resources. The agents from a Keynesian world would appear quite primitive compared to the agents in the sophisticated, forward-looking models of today (Hadjimatheou 1987, p. 4). Two popular attempts at incorporating microfoundations when determining consumption are the life-cycle hypothesis and the permanent income hypothesis (PIH). By placing the agent in an optimizing framework, both models show that consumption is more than simply a function of income. Advantages of these derivations include precise theoretical rationale for determining consumption and expanding the information set upon which consumption may depend. According to Modigliani and Brumberg (1955), according to this theory there need not be any close and simple relation between consumption in a given short period and income in the same period. The rate of consumption in any given period is a facet of a plan which extends 2 over the balance of the individual's life, while the income accruing within the period is but one element which contributes to the shaping of such a plan. This lesson seems to have been largely lost in much of the empirically-oriented discussion of recent years, in the course of which an overwhelming stress has been placed on the role of current income ... almost to the exclusion of any other variable, (pp. 391-392) This paper is cast entirely in terms of the PIH. This framework is chosen because it models consumption in a very reasonable way. Rather than simply using current income, agents utilize the expected future stream of discounted income and current wealth in determining a consumption path, an idea that appears intuitively plausible. Deviations between current consumption and this notion of permanent income, are attributed to surprises, or a transitory component. Using this framework and the assumptions of rational expectations, perfect markets, perfect information, fixed real interest rates, and quadratic utility. Hall (1978) derived the important result that consumption follows a random walk. Given the a.ssumptions of the model, this result makes intuitive sense becau.se consumption in any period will reflect all the information to which the agent is privy. The change in consumption must thus occur as a surprise because it represents something that cannot be foreseen. Current income, of any given lag, would thus provide no information in determining current consumption because all relevant information is embodied in the previous period's level of consumption. This notion of consumption, around which much contemporary work is centered, appears as the antipode of the simple Keynesian consumption function. By using a rational expectations/PIH Hall showed that current consumption depends on nothing beyond its lagged level. Arriving at such a cogent result, however, comes with a very high cost, a cost that must be paid in terms of strong assumptions and diminished flexibility. These assumptions may be considered as being both explicit and implicit. As mentioned, the explicit assumptions are those relating to notions of perfect capital markets, perfect information, fixed interest rates, and quadratic utility. Among the various implicit assumptions used by the rational expectations/ PIH are that adjustment to new information and past errors is very swift (Hadjimatheou 1987, p. 8). As will be seen later in this paper, weakening these assumptions 3 will produces results where information beyond lagged consumption has a significant effect upon current consumption. Because the assumptions of the PIH are central in determining how consumption evolves, much work has been undertaken to study consumption when these conditions are altered. Analysis of two assumptions, that of perfect capital markets and that of rational expectations, form the basis of this paper. Under the assumption of perfect capital markets are notions of the agent's ability to borrow as much as is desired, absence of transactions costs and discrimination, equality among lending and borrowing rates, and perfect and free information. Only with these conditions can the agent smooth consumption as predicted by the PIH. What happens when some or all of these conditions fail to hold is discussed in Chapters 3 through 5, where an alternative form of the PIH is considered. The alternative presented in these chapters incorporates the notion of imperfect capital markets by analyzing the costs that these situations may impose upon agents as they attempt to formulate a consumption plan. Formulating the consumption decision in this manner is sufficiently flexible so as to have the PIH as a .special case. The second assumption addressed in this paper is that of rational expectations. Analysis of this assumption is analyzed in Chapter 5, where the informational requirements of the rational expectations hypothesis are discussed and an alternative method by which expectations may be determined is offered. This alternative permits agents to learn about the system as the sample progresses. Expectations generated in this manner are shown to be very flexible because the expectation-generating mechanism itself will be able to change over time, thereby permitting some degree of structural