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Consumption And Random Walk Hypothesis Notes

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Chen Li

Macroeconomics, Paper 2, Part IIA Essay "Changes in consumption should be unpredictable. Discuss with reference to the empirical evidence."

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 1

Mankiw (2006): p532-4 Doppelhofer (2004): p15 3 Doppelhofer (2004): p14-15 2

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