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# Permanent Income Hypothesis

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Using the following data,
Year 1 2 3 4 5
Actual Income 2 1 3 6 7
and believing that permanent income P[t], which is what we believe, in period t, that our sustainable income will be in period t+1, is determined by:
P[t] = Â½ Y[t] + Â½ Y[t-1]

(a) Write out P[t] for t = 2 to 5.
(b) How does this model compare with the adaptive expectations model?
(c) How "rational" is the model?

https://brainmass.com/economics/keynesian-economics/permanent-income-hypothesis-40640

#### Solution Preview

See the attached file. Thanks.

Using the following data,
Year 1 2 3 4 5
Actual Income 2 1 3 6 7
and believing that permanent income P[t], which is what we believe, in period t, that our sustainable income will be in period t+1, is determined by:
P[t] = Â½ Y[t] + Â½ Y[t-1]

(a) Write out P[t] for t = 2 to 5.
(b) How does this model compare with the adaptive expectations model?
(c) How "rational" is the model?
---------------------
a) P(2)=0.5*Income for year 2+0.5*income for the year 1
P(2)=+0.5*1+0.5*2=1.5
P(3)=0.5*3+0.5*1=2
P(4)=0.5*6+0.5*3=4.5
P(5)=0.5*7+0.5*6=6.5

b) According to the Permanent Income Hypothesis, permanent consumption, CP, is proportional to permanent income, YP. Permanent income is a subjective notion of likely medium-run future income. Permanent consumption is a similar notion for consumption. Actual consumption, C, and actual income, Y, consist of these permanent components plus unanticipated transitory components, CT and YT, respectively.

It is assumed, at least as a first approximation, that the transitory components of consumption and income have expected value 0 and are distributed independently of their permanent counterparts and of each other. To solve the problem that permanent income is unobservable, Friedman hypothesized that it is subject to an adaptive expectations process, permanent income at time t being updated by a proportion of ...

#### Solution Summary

The following problem applies permanent income hypothesis.

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