Direct tests of the permanent income hypothesis under uncertainty, inflationary expectations and liquidity constraints

Abstract

Several studies have argued that the life-cycle permanent income hypothesis (LC-PIH) of Hall (1978) breaks down because of the excess sensitivity of consumption to current income and through consumers failing to exploit information which is available in period t-1. Using direct expectations data based on consumer surveys for the U.S., this study shows that when uncertainty, in particular, and credit constraints are accommodated in the model, consumption is not sensitive to current income. Moreover, contrary to previous empirical findings, the index of consumer confidence is found to be unable to predict consumption. Thus, the theoretical predictions of the rational expectations LC-PIH are unfounded empirically because they fail to accommodate uncertainty, in particular, and credit constraints.