Question 1 - Describe Hall’s findings.
The most basic model of intertemporal optimization by households implies that the change in marginal utility is a martingale difference sequence with respect to lagged information, and hence should be unpredictable; his empirical work found some evidence for predictability based on stock prices. If every deviation of consumption from its trend is unexpected and permanent, then the best forecast of future consumption is just today’s level adjusted for trend. Policies that have a transitory effect on income are incapable of having a transitory effect on consumption.
Question 2 - What assumption does Hall make about the utility function? Is this a good choice in functional form?
Hall assumes that the utility function will be a quadratic function. His results suggest this is a good functional form as consumption would better fit the proposed regression model.
Question 3 - How does Hall turn his theory into a testable hypothesis?
Hall theorises that consumption follows a random walk and that future marginal utility can only be predicted by current consumption, based on the assumption that we are already maximising our utility with regard to our lifetime resources. He therefore hypothesises that there will be no predictive power in models which are lagged for more than one time period. He further restricts this hypothesis by stating that there will be no non-zero coefficient for economic variables in the consumption regression.
Question 4 - What data does he use to test the hypothesis?
The data used throughout the study is quarterly data from the period 1948-1972, collected by the US National Income and Product Accounts, of consumption per capita of nondurables and services, in 1972 dollars. Additionally, Hall uses stock prices as a measure of wealth during his analysis of lagged wealth and consumption.
Question 5 - What does he find to be the impact of lagged wealth changes on consumption? Is this consistent with the Permanent Income Hypothesis?
Hall’s interpretation of the Permanent Income Hypothesis is that lagged wealth changes should not be predictive of consumption in later time periods. To test this, Hall uses stock prices as a proxy variable for wealth, and adds this to the regression model. He finds that the predictive power of the model increases at a statistically significant level, however the improvement is relatively small. Hall states that the majority of the predictive power of wealth comes from the preceding period. This is inconsistent with the Permanent Income Hypothesis.
Question 6 - What are the implications for fiscal policy?
That fiscal policy is more likely to impact consumption if it affects permanent income, and if the policy is unexpected. If the policy is expected, it will already be accounted for in present consumption. If it is transitory, it will have little impact on consumption as it will leave permanent income relatively unchanged.
Bibliography Hall, RE 1978, ‘Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence’, Journal of Political Economy, vol. 86, no. 6, pp. 971-987.