Dundee Discussion Papers in Economics 105: The permanent income hypothesis revisited: reconciling evidence from aggregate data with the representative consumer behaviour

The evidence on the excessive smoothness and sensitivity of consumption with respect to income is sufficiently overwhelming to refute the rational expectations version of the permanent income hypothesis known as the random walk model. This paper proposes an alternative model which (i) is compatible with the “excess smoothness” and the “excess sensitivity” phenomena, (ii) can be interpreted as a rule-of-thumb revision, or smoothing, scheme similar to that proposed by Friedman, and (iii) can also be derived as the solution to a forward-looking intertemporal optimising problem where the rational consumer maximises a time-nonseparable utility function subject to the life-time budget constraint. Data from Canada, the U.K. and the U.S. are used to examine the proposed model. The findings strongly support the theoretical generalisation of the PIH proposed in the paper.