Explore BrainMass
Share

Explore BrainMass

    Permanent Income Hypothesis

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    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] = ½ Y[t] + ½ 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?

    © BrainMass Inc. brainmass.com October 9, 2019, 4:46 pm ad1c9bdddf
    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] = ½ Y[t] + ½ 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.

    $2.19