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The Life-Cycle-Permanent-Income Model: A Reinterpretation and Supporting Evidence

  • Jim Malley
  • Hassan Molana

The consumption path associated with the life-cycle-optimising version of the permanent- income model is commonly agreed to be a random walk with drift. The persisting failure of the latter to conform to data could, however, raise questions about the suitability of the life- cycle-permanent-income framework within which the random walk model is developed. We propose an alternative interpretation of the permanent-income revision rule which implies consumption follows an ARIMA(1,1,0) with drift. We show that this path can also be derived as a solution to a life-cycle optimising problem with habit formation and precautionary saving motives. U.S. data for 1929-2001 strongly supports the model.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2002_17.

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Date of creation: Dec 2002
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Handle: RePEc:gla:glaewp:2002_17
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