Chapter 4 - Permanent Income, Rational Expectations and Government Consumption: A Multi-Country Study

Abstract

This chapter presents a multi-country study on permanent income, rational expectations, and government consumption. It reviews whether the experience of the organization for economic co-operation and development (OECD) countries provides any evidence to support the hypothesis that government expenditures are determined by a government's view of permanent national income. The results from testing this hypothesis will have profound implications for those who believe that a wide range of factors such as changes in the social conditions, in the political climate, and in the demography might exercise an influence on the governmental expenditure because the permanent income hypothesis of government expenditure says that such people are mistaken in their belief as the government expenditure could be explained much more parsimoniously in terms of movements in national income. One problem with testing hypotheses involving expectations is the specification of an expectations generating mechanism. The chapter presents an assumption that expectations are formed rationally so that governments utilize fully the available information set fully in arriving at their permanent income. Such a permanent income-rational expectations (PIRE) hypothesis when applied to aggregate consumption yields the following well known and powerful result: if, in each period, consumption is proportional to permanent income, and if, in turn, permanent income represents the best estimate, given currently available information, of the agent's lifetime resources, then current consumption should deviate from the previous period's consumption by the amount of the contemporaneous revision in permanent income.