Asian Economic and Financial Review THE TESTING OF HALL S PERMANENT INCOME HYPOTHESIS: A CASE STUDY OF PAKISTAN

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1 Asan Economc and Fnancal Revew 2(4: Asan Economc and Fnancal Revew journal homepage: hp://aessweb.com/journal-deal.php?d=5002 THE TESTING OF HALL S PERMANENT INCOME HYPOTHESIS: A CASE STUDY OF PAKISTAN Khald Khan Manzoor H Memon Che 2 ABSTRACT The objecve of hs sudy s o es he Hall s permanen ncome hypohess for Paksan usng annual daa from 992 o 200. The basc model of permanen ncome hypohess (PIH showed he valdy of absolue ncome hypohess (AIH whle he Campbell and Mankw (990 consumpon model suggesed ha he proporon of forward lookng consumers n oal populaon s 32 percen and he remanng consumers are backward lookng. Therefore n Paksan, here s larger flucuaon n per capa ncome and small opporuny for consumpon smoohng. Key Words: Permanen Income Hypohess, Absolue Income Hypohess, Consumpon Smoohng INTRODUCTION Accordng o permanen ncome hypohess (PIH he consumpon of ndvduals depend upon her permanen ncome raher han curren ncome. To es he PIH, Fredman (957 suggesed ha ndvduals can esmae her permanen ncome on he bass of curren ncome lags. Thus Fredman nroduces lags n consumpon funcon. Lucas (976 argued ha lags of curren ncome canno explan he curren consumpon. In response o hs crque, Hall (978 presened heory of raonal expecaon-permanen ncome hypohess (RE-PIH. He argued ha curren consumpon s adequae o esmae fuure consumpon because any nformaon whch affecs fuure consumpon s already ncluded n curren consumpon. Hall furher explaned ha he dsposable ncome, boh curren and pas, have no effec on fuure consumpon. Therefore accordng o Hall, consumpon follows a random walk. Flavne (98, Hayash (982, Bernanke (985, Campbell and Mankw (990, Rao (2005, Rao (2007, have esed he Hall s random walk hypohess bu her resuls do no even parly suppor he RE-PIH. In Paksan, Khald (994 explcly esed he Hall s random walk hypohess and he concluded ha Hall s random walk hypohess s no vald for Paksan. Khald (994 neher used Euler equaon approach nor he Campbell and Mankw (990 consumpon model, whch separaes he Lecurer, Unversy of Agrculure, Waer and Marne Scences, (LUAWMS, Uhal, Balochsan 2 Senor Manger (Lead Economs, JCR-VIS Cred Rang Co. Ld. Karach. 445

2 Asan Economc and Fnancal Revew 2(4: proporon of forward lookng consumers from backward lookng consumers. Ths sudy uses boh Euler equaon approach and Campbell and Mankw (990 consumpon model o es he PIH for Paksan and hence presens a conrbuon o exsng leraure. The res of he paper s organzed as follows, secon wo descrbes mehodology and daa, secon hree presens he emprcal resuls and secon four offers concluson. METHODOLOGY AND DATA DESCRIPTION The poneer of esng PIH under he raonal expecaon wh Euler equaon was Hall (978. Accordng o PIH aggregae consumpon funcon can be represened by he ndvdual s decson. Thus he ypcal ndvdual maxmzes: MaxE T 0 ( U ( C U 0, U 0 ( Subjec o Where T 0 ( r ( C YL W C E T W YL Prvae consumpon a perod Expecaons subjec o nformaon a perod Lfe me of he ndvdual Wealh excludng human capal a perod Dsposable labor ncome a perod Rae of subjecve me preference r Real rae of neres The frs order condon (Euler equaon can be obaned from he maxmzaon of above equaon ( as: E U ( C U ( C (2 Ths equaon says ha margnal uly of oday wh consan mulple s he bes forecas of margnal uly of omorrow. If we assume ha margnal uly s lnear and r bes predcor n he nex perod consumpon:, hen we fnd ha curren consumpon s he Ths n urn mples: E ( C C (3 C (4 446

3 Asan Economc and Fnancal Revew 2(4: Where s a raonal forecasng error and nnovaon n permanen ncome. Thus, accordng o hs arrangemen of he permanen ncome hypohess, he change n consumpon s canno be forecased. To es he basc model PIH wh he daa, for hs purpose he economerc model s as under: C (5 Y Where C s log dfference of real consumpon, Y s log dfference of curren real labor ncome, s random error. If 0 hs shows he valdy of PIH, oherwse shows ha curren ncome can effec curren consumpon. In he above model we assume ha all consumers are forward lookng. Bu n he real world may no be possble. Therefore, we also used he Campbell and Mankw (990 consumpon model o fnd ou he separae proporon of forward lookng and backward lookng consumers. Campbell and Mankw (990 Consumpon Model The Campbell and Mankw model assumes ha he proporon of ( ndvduals are forward lookng and sasfy he PIH whle a proporon of ( follow he rule of humb and consume her curren ncome. Furhermore, he Campbell and Mankw consumpon model also allows some neremporal subsuon ( for he forward lookng consumers. Thus he Campbell and Mankw consumpon model s: C Y (. r (6 Where r s he real neres rae, s he random erm. Daa Descrpon The sudy s based on an annual daa from 992 o 200 and s aken from he Inernaonals Fnancal Sascs (IFS daabase. All he daa seres are used n her real denomnaons. The real consumpon s used as a dependen varable. Real consumpon s compued by adjusng nomnal consumpon wh consumpon deflaor. Gross domesc produc (GDP s used as a proxy for labor ncome because GDP s hghly correlaed wh labor ncome; and s real value s obaned by deflang wh consumpon deflaor. The dscoun rae s used as a proxy of real neres rae afer nflaon adjusmen and Consumer Prce Index (CPI s used as he consumpon deflaor. EMPIRICAL RESULTS The esmaed resul of he basc model of PIH and Campbell and Mankw consumpon model are presened n able. Three dfferen economerc mehods.e. Ordnary Leas Square (OLS, Insrumen-Varable (IV and Non-Lnear Leas Squares (NLLS were used o esmae equaons (5 and (6. The hrd and fourh column of able presens he resuls of basc model of PIH, whch shows ha here s srong and sgnfcan relaonshp beween change n consumpon and change n curren ncome, hese resuls are conssen wh AIH. Thus, ndcaes ha he ndvduals consumpon srongly rely on her curren ncome raher han her expeced lfe me ncome. Therefore he resuls of Basc model of PIH show he nconssency of PIH. The above esmaon assumes ha all ndvduals are forward lookng bu n real world may no be possble. Therefore, he sudy used he Campbell and Mankw consumpon model. The Campbell and Mankw consumpon model whch ncludes boh ypes of consumers: forward 447

4 Asan Economc and Fnancal Revew 2(4: lookng and backward lookng. The bes way o esmae he Campbell and Mankw model s nsrumen-varable (IV approach as suggesed by Campbell and Mankw (990 because he error erm may be correlaed wh Y and due o hs he OLS esmaors wll become nconssen. The emprcal resuls of he Campbell and Mankw consumpon model suppor he resul of basc model of PIH. All hree esmaon mehods ndcaed he presence of small number of forward lookng ndvduals. The proporon of forward lookng consumers s 32 percen, 22 percen, and 33 percen of he oal populaon, shown by he OLS, IV and NLLS regresson respecvely. Therefore boh he basc model of PIH and Campbell and Mankw model show he volaon of PIH for Paksan. The real neres rae appears wh a negave sgn bu s sascally nsgnfcan n all OLS, IV and NLLS regresson. Therefore n he case of Paksan curren ncome plays a very val role n deermnaon of ndvduals consumpon. Thus consumpon does no follow a random walk n Paksan. CONCLUSION Ths sudy esed he Hall s permanen ncome hypohess of Paksan usng he basc model of PIH and Campbell and Mankw (990 consumpon model. The basc model of PIH showed ha he consumers consumpon n Paksan depends upon her curren ncome raher han permanen ncome hence ndcaed he valdy of he AIH. The same resuls are found by he Campbell and Mankw (990 consumpon model. On he bass of Campbell and Mankw consumpon model we found ha he proporon of backward lookng consumers s much greaer han he forward lookng consumers, only 33 percen of consumers consumpon choces are based on permanen ncome and he remanng follow he rule of humb. The real neres rae has a correc sgn bu sascally nsgnfcan n all hree models smulaneously. I s hoped hs sudy resuls wll encourage furher work on mcro daa analyss of PIH. Table Esmaon of Basc Model of PIH and Campbell and Mankw Consumpon Model C C Y (. r Y ( SE.OLS Coeffcen T. Rao Probably IV Coeffcen T. Rao Probably IV-NLLS Coeffcen T. Rao Probably Noe: For he esmaon of IV and IV-NLLS model we used y, y 2, y 3, r, r 2 and r 3 as nsrumenal varables 448

5 Asan Economc and Fnancal Revew 2(4: REFERENCES Bernanke, B. S., (985 "Adjusmen Coss, Durables Aggregae Consumpon Week Wse Course Oulnen" Journal of Monory Economcs Vol.5, pp Campbell, J.Y. and Mankw, N.G. (990 "Permanen Income Curren Income and Consumpon" Journal of Busness and Economc Sasc Vol.8, pp Flavn, M. A. (98 "The Adjusmen of Consumpon Changng Expecaons abou Fuure Income" Journal of Polcal Economy Vol.89, pp Fredman, M. (957 A Theory of Consumpon Funcon, Prnceon, NJ: Prnceon Unversy Press. Hall, R, E. (978 "Sochasc Implcaons of he Lfe Cycle Permanen Income Hypohess: Theory and evdence" Journal of Polcal Economy Vol.86, pp Hall and Fredrc, S. M. (982 "The Sensvy of Consumpon o Transory Income: Esmaes from panel daa on Households" Economerca Vol.50, pp Hayash, F., (982 "The Permanen Income Hypohess: Esmaon of Tesng Insrumenal Varables" Journal of Polcal Economy, Vol.90, pp Khald, A. M. (994, Emprcal Tes of he Raonal Expecaon and Permanen Income Hypohess Evdence from Paksan. The Paksan Developmen Revew, Volume 33, pp Lucas, Rober E. Jr (976, Economerc Polcy Evaluaon: A Crque. In Carnege-Rocheser Conferences on Publc Polcy, Rao, B.B., (2005, Tesng Hall s Permanen Income Hypohess for Developng Counry: The Case of Fj. Appled Economcs Leers, Volume, 2, pp Rao, B.B., (2007, Tesng he Permanen Income Hypohess n Developed Counres a Comparson beween Fj and Ausrala. School of Economcs Unversy of he Souh Pacfc, workng paper No 2007/09 449