Purchase Solution

Permanent Income Hypothesis

Not what you're looking for?

Ask Custom Question

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?

Purchase this Solution

Solution Summary

The following problem applies permanent income hypothesis.

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 ...

Purchase this Solution


Free BrainMass Quizzes
Pricing Strategies

Discussion about various pricing techniques of profit-seeking firms.

Elementary Microeconomics

This quiz reviews the basic concept of supply and demand analysis.

Basics of Economics

Quiz will help you to review some basics of microeconomics and macroeconomics which are often not understood.

Economic Issues and Concepts

This quiz provides a review of the basic microeconomic concepts. Students can test their understanding of major economic issues.

Economics, Basic Concepts, Demand-Supply-Equilibrium

The quiz tests the basic concepts of demand, supply, and equilibrium in a free market.