Pakistan Institute of Development Economics



Empirical Tests of the Rational Expectations – Permanent Income Hypothesis: Evidence from Pakistan

The permanent income hypothesis postulates that at a given point in time, an individual’s consumption is determined by his lifetime resources and not by his income. Thus, the hypothesis suggests that an individual’s consumption will respond only to changes in permanent income. The insertion of the rational expectations theory into Friedman’s permanent income hypothesis by Hall (1978),-called the Rational Expectations/Permanent Income Hypothesis (thereafter RE/PIH)changed this view, and suggested that current aggregate consumption is determined only by its own lag. Any information that may help in determining current consumption is already included in last period’s consumption. Hence consumption follows a random walk. The testable implication of Hall’s hypothesis is that apart from the current period’s consumption expenditure, any variable observable in this or earlier periods should not show any predictive power for the next period’s consumption expenditure. Therefore, additional lagged values of consumption or any other variable that can reasonably be assumed to be in the consumer’s information set at time t should not be statistically significant if regressed over current consumption.

Ahmad H. Khalid

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