Permanent Income and Transitory Variation in Investment and Output

Abstract

The authors use the permanent income hypothesis as the framework to analyze a number of results from recent empirical macroeconomic research. First, they demonstrate that the shock isolated in both the three and six variable models of King, Plosser, Stock, and Watson (1991) depends mainly on the time-series behavior of the reduced form consumption residual. A permanent income hypothesis interpretation of this finding is that consumption fully reflects the implications of long-lived shocks for the common stochastic trend in consumption, investment, and output. Further, for the three variable model, shocks to consumption have permanent effects on the levels of the series while shocks to investment and output have only transitory effects, given that consumption is ordered first in a causal ordering. The permanent income interpretation is that shocks to productivity are changes in permanent income, and, hence, are fully reflected through consumption decisions. From this perspective, consumption shocks are proxies for the changes in permanent income generated by the shocks. The results complement the findings in Hall (1978) and Campbell (1987) and generalize Cochrane's (1994) analysis to a model that includes investment.