The permanent income hypothesis in five major industrial countries: a multivariate trend-cycle decomposition test

Abstract

This paper presents a new test of the permanent income hypothesis in five major industrial countries. The test first decomposes consumption and income into their long run trend (permanent) and short run cyclical (transitory) components, using the recently developed multivariate stochastic detrending approach developed by Vahid and Engle (1997), among others. This approach exploits the presence of possible common stochastic trends and cycles among the variables in the system to arrive at a more efficient decomposition of these variables. Using the decomposition results, and in contrast to many articles in the literature, the paper finds support for the permanent income hypothesis. Specifically, the paper finds that, while permanent consumption is related to permanent income, transitory consumption is related to neither permanent nor transitory income.