Reexamining the permanent income hypothesis with uncertainty in permanent and transitory innovation states
In this paper, we reexamine the permanent income-consumption relationship analytically and empirically, based on the innovation regime-switching (IRS) model developed in [Kuan, C.M., Huang, Y.L., Tsay, R.S., 2005. An unobserved component model with switching permanent and transitory innovations. Journal of Business and Economic Statistics, 23, 443-454]. A novel feature of the IRS model is that it explicitly allows for uncertainty in innovation states. When the labor income follows an IRS process, it is shown that the agent's perception on the likelihoods of income innovations being permanent and transitory plays a crucial role in determining the optimal forecasts on the change of consumption. The effect of a current labor income innovation on consumption is a weighted average of two distinct effects resulting from permanent and transitory innovations with the weights equal to the perceived likelihoods of the respective states. Also, past innovations may affect consumption when there are revisions in the perceived likelihoods of previous states. Our empirical study on US data shows that consumption indeed reacts significantly to the perceived likelihoods of innovation states. However, even after controlling for the effect of state uncertainty, we find consumption vastly underreacts to permanent innovations in labor income but reacts about the right magnitude to transitory ones when compared with the prediction of the permanent income hypothesis. This evidence is similar to [Elwood, S.K., 1998. Testing for excess sensitivity in consumption: A state-space unobserved components approach. Journal of Money, Credit, and Banking, 30, 64-82] but in sharp contrast with that found in [Hall, R.E., Mishkin, F.S., 1982. The sensitivity of consumption to transitory income: Estimates from panel data on households. Econometrica, 50, 461-480].
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Hansen, Bruce E, 1996.
"Inference When a Nuisance Parameter Is Not Identified under the Null Hypothesis,"
Econometric Society, vol. 64(2), pages 413-30, March.
- Hansen, B.E., 1991. "Inference when a Nuisance Parameter is Not Identified Under the Null Hypothesis," RCER Working Papers 296, University of Rochester - Center for Economic Research (RCER).
- Tom Doan, . "TAR: RATS procedure to estimate a threshold autoregression, tests for threshold effect," Statistical Software Components RTS00209, Boston College Department of Economics.
- Tom Doan, . "RATS programs to replicate Hansen's threshold estimation and testing results," Statistical Software Components RTZ00091, Boston College Department of Economics.
- Martin Evans & Paul Wachtel, 1993. "Inflation regimes and the sources of inflation uncertainty," Proceedings, Federal Reserve Bank of Cleveland, pages 475-520.
- Campbell, John Y, 1987.
"Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis,"
Econometric Society, vol. 55(6), pages 1249-73, November.
- John Y. Campbell, 1986. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," NBER Working Papers 1805, National Bureau of Economic Research, Inc.
- John Y. Campbell & N. Gregory Mankiw, 1987.
"Permanent Income, Current Income, and Consumption,"
NBER Working Papers
2436, National Bureau of Economic Research, Inc.
- Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
- Kenneth D. West, 1987.
"The Insensitivity of Consumption to News About Income,"
NBER Working Papers
2252, National Bureau of Economic Research, Inc.
- West, Kenneth D., 1988. "The insensitivity of consumption to news about income," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 17-33, January.
- Robert F. Engle & Aaron D. Smith, 1999.
"Stochastic Permanent Breaks,"
The Review of Economics and Statistics,
MIT Press, vol. 81(4), pages 553-574, November.
- Engle, Robert F & Smith, Aaron, 1998. "Stochastic Permanent Breaks," University of California at San Diego, Economics Working Paper Series qt99v0s0zx, Department of Economics, UC San Diego.
- Falk, Barry L. & Lee, Bong-Soo, 1998. "The Dynamic Effects of Permanent and Transitory Labor Income on Consumption," Staff General Research Papers Archive 1223, Iowa State University, Department of Economics.
- Robert E. Hall & Frederic S. Mishkin, 1980.
"The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households,"
NBER Working Papers
0505, National Bureau of Economic Research, Inc.
- Hall, Robert E & Mishkin, Frederic S, 1982. "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households," Econometrica, Econometric Society, vol. 50(2), pages 461-81, March.
- Falk, Barry & Lee, Bong-Soo, 1998. "The dynamic effects of permanent and transitory labor income on consumption," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 371-387, April.
- John Y. Campbell & N. Gregory Mankiw, 1986.
"Are Output Fluctuations Transitory?,"
NBER Working Papers
1916, National Bureau of Economic Research, Inc.
- Kuan, Chung-Ming & Huang, Yu-Lieh & Tsay, Ruey S., 2005. "An Unobserved-Component Model With Switching Permanent and Transitory Innovations," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 443-454, October.
- Hansen, Lars Peter & Sargent, Thomas J., 1980.
"Formulating and estimating dynamic linear rational expectations models,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 2(1), pages 7-46, May.
- Lars Peter Hansen & Thomas J. Sargent, 1979. "Formulating and estimating dynamic linear rational expectations models," Working Papers 127, Federal Reserve Bank of Minneapolis.
- Beaudry, Paul & Koop, Gary, 1993. "Do recessions permanently change output?," Journal of Monetary Economics, Elsevier, vol. 31(2), pages 149-163, April.
- Francis X. Diebold & Glenn D. Rudebusch, 1989.
"Is consumption too smooth? Long memory and the Deaton paradox,"
Finance and Economics Discussion Series
57, Board of Governors of the Federal Reserve System (U.S.).
- Diebold, Francis X & Rudebusch, Glenn D, 1991. "Is Consumption Too Smooth? Long Memory and the Deaton Paradox," The Review of Economics and Statistics, MIT Press, vol. 73(1), pages 1-9, February.
- Campbell, John & Deaton, Angus, 1989.
"Why Is Consumption So Smooth?,"
3221494, Harvard University Department of Economics.
- Marjorie Flavin, 1993. "The Excess Smoothness of Consumption: Identification and Interpretation," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 651-666.
- Elwood, S Kirk, 1998. "Testing for Excess Sensitivity in Consumption: A State-Space/Unobserved Components Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(1), pages 64-82, February.
- Alan S. Blinder & Angus Deaton, 1985. "The Time Series Consumption Function Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(2), pages 465-521.
- Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
- Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, number 9780198288244, December.
- Bradley, Michael D & Jansen, Dennis W, 1997. "Nonlinear Business Cycle Dynamics: Cross-country Evidence on the Persistence of Aggregate Shocks," Economic Inquiry, Western Economic Association International, vol. 35(3), pages 495-509, July.
- Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
- David Demery & Nigel W. Duck, 2000. "Incomplete information and the time series behaviour of consumption," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 15(4), pages 355-366.
- Gray, Stephen F., 1996.
"Modeling the conditional distribution of interest rates as a regime-switching process,"
Journal of Financial Economics,
Elsevier, vol. 42(1), pages 27-62, September.
- Tom Doan, . "RATS programs to replicate Gray's 1996 Regime Switching GARCH paper," Statistical Software Components RTZ00080, Boston College Department of Economics.
When requesting a correction, please mention this item's handle: RePEc:eee:jmacro:v:30:y:2008:i:4:p:1816-1836. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)
If references are entirely missing, you can add them using this form.