An Alternative Econometric Approach to the Permanent Income Hypothesis: An International Comparison

Abstract

PpTHE theory of aggregative consumption function has undergone several developments since Kuznets' [27] saving-income estimates for the United States showed disagreement with Keynes' [ 2 1 ] fundamental psychological rule. Noteworthy among these developments are the Relative Income Hypothesis [10] the Life-Cycle Hypothesis [33] and the Permanent Income Hypothesis [ 13 ]. Although these different hypotheses are rather complementary yet the Permanent Income Hypothesis (PIH) has been more widely studied than the others. According to the PIH, measured income and consumption are composed of two components permanent and transitory. Under the assumption of zero correlation between transitory and permanent and also between the two transitory components, postulates that permanent consumption constitutes a constant proportion of permanent income. The basic concepts of permanent income and consumption, although theoretically attractive, involved considerable difficulties in regard to their measurability. This stimulated a number of debates and empirical researches. Some corroborated the PIH, while others showed a strong disagreement over some of its major assumptions. A close investigation of these debates and researches suggests that Friedman's own proposal to use Cagan's [7] distributed lag scheme, as one of the alternatives for constructing an estimate of permanent income in time series studies, has perhaps invited more troubles than actually solved. Clearly, does not allow for a separation of the permanent and transitory components from the observed data.' It is not surprising then that Laumas [28] and Choudhury [8] can obtain significant marginal propensities to consume transitory income for Canada and India respectively, and that Walters [41] can show a relationship between transitory and permanent income. A cursory look at such studies may sometimes shatter the faith in the strict version of the PIH but if one studies them more carefully one feels inclined to speak with Ovid it often happens that the material is better than the workmanship. The purpose of the present paper is two-fold: first, to improve upon the workmanship and second, to investigate whether the PIH is applicable to economies with different structures. The improvement in the 'workmanship' lies in the application of Nonlinear Iterative Least Squares (NILES) procedure 2 to estimate the coefficient of proportionality when both permanent income and consumption are unknown. The advantages of this method over the commonly used Ordinary Least Squares procedure are that overcomes the problem of identification in the consumption function arising from the nonlinearity of parameters and that yields individual estimates of the parameters with least squares properties. In addition to this, is computationally more convenient than other nonlinear procedures. This method has been applied on the one hand to the existing approach in which the estimate of permanent income has been defined in terms of Cagan's distributed lag scheme, and on the other hand to an alternative approach in which considers the PIH on the lines of the classical two-variables linear model where both variables are subject to errors of observation. In neither case do we violate any of Friedman's assumptions. The advantage of the second approach lies in the fact that the estimation of permanent income does not require any extraneous informa* The authors would like to express their gratitude to Professors A. R. Dobell, S. J. Turnovsky and T. A. Wilson for constructive criticism and encouragement, and to the referee for helpful comments on an earlier draft of this paper. Needless to say, the responsibility for any errors lies with the authors alone. 'Singh [38], pp. 3-6. 2For the NILES procedure see Wold [43], pp. 433-434 and 438-440.