1. Describe Hall’s findings.
Hall found that with the pure life cycle-permanent income hypothesis, consumption cannot be predicted by any variable dated prior to the assessed period other than by using the data from period immediately prior. The stock market is also seen to be valuable in predicting consumption 1 quarter in the future. Most of this predictive power is coming from the change in stock price in the period immediately prior to the period being tested. However the data does seem entirely compatible with a modification of the hypothesis that leaves its central content unchanged. Specifically some part of consumption takes time to adjust to a change in permanent income.
2. What assumption does Hall make about the utility function? Is this a good choice in functional form?
Hall assumes the utility function is quadratic, implying a concave function. This concave function ensures that people have a point of optimisation, as well as diminishing returns to marginal utility around this point. He also notes that the optimal consumption choice of the consumer is governed by the Euler equation, as the Euler equation relates the key variables of the model over time along with their utility maximizing path.
3. How does Hall turn his theory into a testable hypothesis?
Hall turns his theory into a testable hypothesis by estimating a conditional expectation, \(E\), including \(x_{t-1}\) which is a vector of data known in period \(t-1\). He can then test the hypothesis that the conditional expectation is actually not a function of \(x_{t-1}\), also known as an F-test.
4. What data does he use to test the hypothesis?
Hall uses the quarterly data of consumption of nondurables and services in 1972 dollars from the U.S. National Income and Product Accounts divided by the population. Whilst the lagged wealth tests are based on Standard and Poor’s comprehensive index of the prices of stocks deflated by the implicit deflator for nondurables and services and divided by population.
5. What does he find to be the impact of lagged wealth changes on consumption? Is this consistent with the Permanent Income Hypothesis?
Hall finds that the impact of lagged wealth changes on consumption is due to some part of consumption taking time to adjust to the change in permanent income. Although the lagged wealth change the period immediately preceding the quarter in question is responsible for most of the predictive value. This finding is inconsistent with the pure life cycle-permanent income hypothesis, that being consumption cannot be predicted by any variable prior to the period of consumption other than the period immediately prior. However the data is entirely compatible with a modification of the hypothesis that leaves its central content unchanged.
6. What are the implications for fiscal policy?
Halls results have the following implications for fiscal policy: Expected changes in policy will already be incorporated into present consumption and thus will not affect it as it is nothing new. Unexpected changes in policy will affect consumption only to the extent to which they affect permanent income, at which point their effects are expected to be permanent. Fiscal policies which have a transitory effect on income are incapable of having a transitory effect on consumption. Fiscal policy only affects consumption when it is not expected and only to the extent it affects permanent income.