This week’s homework is based on Robert Hall’s 1978 paper “Stochastic implications of the Life Cycle-Permanent Income Hypothesis: Theory and evidence”, available here: http://web.stanford.edu/~rehall/Stochastic-JPE-Dec-1978.pdf. Give it a good read or two. There will be a few new concepts in the paper.
- Euler equation (Euler was Swiss, so we pronounce his name “Oyler”). The Euler equation is one that can help to characterise the equilibrium of a dynamic optimisation problem. It relates the key variables in the model over time along their utility-maximising path.
- Random walk. This is a series whose changes cannot be predicted, other than with a trend. While all random walk series have a unit root, not all unit root series are a random walk. (why?)
- F-test. This is a method of testing whether a simpler model does a better job of explaining the data than a more complex model that contains all the variables in the simple model and some more.
Questions
- Describe Hall’s findings.
- What assumption does Hall make about the utility function? Is this a good choice in functional form?
- How does Hall turn his theory into a testable hypothesis?
- What data does he use to test the hypothesis?
- What does he find to be the impact of lagged wealth changes on consumption? Is this consistent with the Permanent Income Hypothesis?
- What are the implications for fiscal policy?