Partial adjustment and the permanent income hypothesis

Abstract

The paper extends the permanent income hypothesis to incorporate two alternative theories of partial adjustment. The first is the conventional forward-looking quadratic costs of adjustment model; the second develops the idea that adjustment of consumption to changes in permanent income are faster the more advanced is the notice of such changes. Both theories can in principle account for the ‘excess smoothness’ and ‘excess sensitivity’ phenomena highlighted in recent research. Both models are applied to U.S. and U.K. quarterly data. The second model appears to provide a more satisfactory explanation of consumption in the two countries.