Permanent Income Hypothesis, Myopia and Liquidity Constraints: A Case Study of Pakistan

Transcription

1 Pakisan Journal of Social Sciences (PJSS) Vol. 3, No. (December 0), pp Permanen Income Hypohesis, Myopia and Liquidiy Consrains: A Case Sudy of Pakisan Khalid Khan Lecurer of Economics Lasbela Universiy of Agriculure, khalidkk8@yahoo.com Mohammed Nisha Professor of Finance and Economics, Insiue of Business Adminisraion (IBA), Karachi mnisha@iba.edu.pk Absrac In his paper, i is aemped o es he permanen income hypohesis (PIH) for Pakisan. If he PIH is no valid for Pakisan he sudy also aemps o find ou he reasons for rejecion of PIH. Hall s random walk model (978) and Campbell and Mankiw model (990) are used o es for he validiy of PIH. The resuls of his sudy indicae he srong validiy of absolue income hypohesis (AIH) raher han PIH. Therefore, o find ou he reasons for he rejecion of he PIH in Pakisan we used Shea (995) model. The resuls of he Shea (995) model rejeced he symmeric relaionship beween consumpion and expeced income and provide a lile evidence of exisence of liquidiy consrains. Keywords: Permanen Income Hypohesis; Absolue Income Hypohesis; Symmeric Relaionship; Liquidiy Consrains I. Inroducion The empirical puzzle of Keynes psychological law of consumpion provides he opporuniy o exend he consumpion lieraure. To answer Kuznes s (946) empirical puzzle, differen economiss inroduced heir consumpion heories such as relaive income hypohesis (RIH) by Duesenberry (948), life cycle hypohesis (LCH) by Modigliani and Brumbergh (954) and permanen income hypohesis (PIH) by Friedman (957). According o Duesenberry (948) consumpion of he individual depends upon is relaive income raher han is absolue income. Bu according o PIH consumpion of individual which is explained by is permanen raher han is relaive income and curren income, while he LCH forwards he same argumen in a differen prospecive. According o LCH he consumpion of individual is explained by is expeced life ime income, so he PIH and LCH share he same opimizaions model and conclusion. Bu in empirical work he PIH is more popular han LCH, while he RIH is no esed widely because of unavailabiliy of daa for key variables. To es he PIH, Friedman (957) esimaed he permanen income by using he disribuive lags of curren income. Lucas (976) posulaed ha he lags of curren income do no explain he curren consumpion. In he response o Lucas (976) criique, Hall (978) showed ha wihou curren consumpion oher variables have no

2 300 Pakisan Journal of Social Sciences Vol. 3, No. explanaory power o predic fuure consumpion i.e. change in consumpion is a random walk. Hall s random walk hypohesis implies ha unexpeced change in permanen income can affec curren consumpion. Several empirical sudies esed he Hall s random walk hypohesis. The mos noable among hem are Flavin (98), Hall and Mishkin (98), Hayashi (98), Bernanke (985), Campbell and Mankiw (990), bu heir resuls were no suppored by Hall s Random walk hypohesis. They argued ha individual s consumpion is sensiive o curren income raher han permanen income and Flavin (98) gave he name o such phenomenon as excess sensiiviy of consumpion. Before Campbell and Mankiw (990) economis believe ha an economy can saisfy one consumpion hypohesis a a ime bu in (990) Campbell and Mankiw showed ha in an economy consumers can saisfy boh absolue income hypohesis (AIH) and permanen income hypohesis (PIH) simulaneously. Campbell and Mankiw divided consumers in wo differen segmens i.e. λ and (- λ ), λ shows he proporion of backward looking consumers, while (- λ ) shows he proporion of forward looking consumers. Khalid (994) esed he PIH for Pakisan, using disribuive lag model. His resuls show ha PIH is no valid in Pakisan bu he did no show any reason for he failure of PIH. Since in consumpion lieraure, here are wo reasons for he rejecion of PIH, one is liquidiy consrains (Zeldes (989)), and anoher is myopia (Runkle (99)). In case of liquidiy consrains consumers are unable o borrow agains heir fuure income bu hey can save freely when heir curren income increases. Therefore, liquidiy consrains show an asymmeric relaionship beween consumpion and expeced income. Bu myopia consumpion follows curren income, because in myopia, consumers respond equally o predicable income increases and decreases. Therefore, myopia causes symmeric relaionship beween consumpion and expeced income. Flavin (985), Zeldes (989) Jappelli & Pagano (989) rejeced he PIH, heir resuls showed ha he excess sensiiviy of consumpion o curren income is due o liquidiy consrains. Paz (006) esed he PIH for Brazil and rejeced he PIH due o he presence of boh liquidiy consrains and myopia. Gomes and Paz (00) esed he life cycle permanen income hypohesis for Brazil, Colombia, Peru and Venezuela. Gomes and Paz (00) found liquidiy consrained consumers in Brazil and Colombia, and perverse asymmery in Peru while heir resuls were remained uninformaive abou consumpion in Venezuela. This is he firs sudy o es he PIH wih he help of Hall s random walk model (978) and Campbell and Mankiw model (990) in case of Pakisan. Besides ha his sudy is also ineresed o find ou he rejecion reasons of he PIH in Pakisan, if AIH is valid for Pakisan. The res of he paper is organized as follows: Secion wo offers mehodology and daa descripion, secion hree presens he resuls and discussion and secion four summarizes conclusion.

3 Khalid Khan, Mohammed Nisha 30 II. Mehodology and Daa Descripion In consumpion lieraure here are several consumpion heories, namely, absolue income hypohesis (AIH), permanen income hypohesis (PIH), life cycle income hypohesis (LCH) and random walk hypohesis (RWH). This sudy considers he Hall (978) random walk model o es he absolue income and permanen income hypohesis wih raional expecaion for Pakisan. Adoping he Hall (978) ha he ypical forward looking consumer maximizes: E + s= 0 s ( + δ ) u( C s ) > 0, u < 0 E = expecaion a period C = privae consumpion a period u = uiliy funcion of individual δ = rae of subjecive ime preference u (.) If he represenaive individual can lend and borrow a a real ineres rae r, hen he firs order condiion from he above maximizaion is: + δ E u ( C ) u + = ( C ) + r δ (.) If we assume ha r = and he marginal uiliy ( u ) is linear or log linear hen we finds ha he curren consumpion is he bes forecas of fuure consumpion in he nex period, i.e.: C = + ε + C (.3) or Therefore, E C = C + (.4) C = ε (.5) Where ε is random error, he above equaion (.5) implies ha all he available informaion is used in curren period o forecas he fuure consumpion. a. Economeric Model To es he PIH, for his purpose he sudy uses he following model: C = α + λ Y + ε (.6) Where C consumpion growh, Y PIH will be saisfied. is expeced income growh. When = 0 λ hen

4 30 Pakisan Journal of Social Sciences Vol. 3, No. The Campbell and Mankiw (990) allow he ineres rae in he above equaion (.6) for ineremporal subsiuion for he forward looking consumer. Then he augmened model becomes: C = µ + λ Y + σ. r + ε (.7) Where r is real expeced ineres rae. The PIH posulaed ha predicable changes in income have no affec on consumpion bu consumpion can only be affeced hrough ineres rae. Therefore, if ( λ ) equals o zero i shows he validiy of PIH. Under myopia, consumers consume a fixed share of curren income. Therefore, consumpion should respond symmerically o he increases and decreases of expeced income. While, under liquidiy consrains, individual consumpion should respond more srongly o increase of expeced income han decrease of expeced income. This asymmerical behavior is because under he liquidiy consrains, individuals canno borrow bu save freely. Following Shea (995) model, in order o es he presence of liquidiy consrains and myopia, following regression was used: C = µ + λ POS Y NEG Y. r + ( ) + λ ( ) + σ ε (.8) Where POS and NEG are dummies variables for periods in which > 0 and Y < 0 respecively. The PIH implies ha boh λ = λ = 0 λ' s Y, under myopia he should be significan, equal and greaer han zero, while in liquidiy consrains implies ha: λ is posiive, significan and greaer han λ. b. Daa and Variables The daa is colleced on annual basis from 97 o 00 a he Inernaional Financial Saisics (IFS) CD-ROM. The daa consiss of real disposable income, real consumpion, real ineres rae and consumer price index (CPI). The deail and definiion of variables are as under: Real Privae Consumpion Nominal privae consumpion is used as a proxy of consumpion. I includes boh he consumpion of durable and non-durable goods, bu i does no include he governmen consumpion of emerging economies. The real consumpion was calculaed by deflaing nominal consumpion wih consumpion deflaor Labor Income GDP is used as a proxy for labor income, because GDP is highly correlaed wih labor income; real value was obained by deflaing he nominal value wih consumpion deflaor. Labor income is one of he major sources of curren income. I is srongly posiively relaed o he privae consumpion, due o his i is expeced ha he sign of labor income will be posiive.

5 Khalid Khan, Mohammed Nisha 303 Real Ineres Rae Campbell and Mankiw (990) used discoun rae as he proxy of ineres rae hence his sudy also used discoun rae as a proxy of real ineres rae afer adjusing wih inflaion. Consumpion Deflaor The Consumer Price Index (CPI) is used as he consumpion deflaor. Wih he help of CPI we convered all nominal variables o heir real counerpars. III. Empirical Resuls a. Descripive Saisics Table Comparison of Consumpions Paerns of Pakisan wih China and India Counry Name PAKISTAN CHINA INDIA Mean APC Sandard Deviaion of APC Mean Growh of Y Sandard Deviaion of Growh in Y Mean Growh of C Sandard Deviaion in C Where: APC is average propensiy o consume, Y is gross domesic produc and C is privae consumpion Before he esimaion of Hall s (978) and Campbell and Mankiw (990) consumpion model, firs, we wan o compare he average propensiy o consume (APC) in Pakisan wih China and India. This purpose can be achieved wih he help of able in which he APC, sandard deviaion of APC, average growh of income and consumpion and heir respecive sandard deviaion for Pakisan, China and India are calculaed. In able he APC of Pakisan China, India are 0.73, 0.58 and 0.67 respecively. There is prey high difference beween he APC of Pakisan and China while small difference beween APC of Pakisan and India. The sandard deviaion of APC of China is very low han he sandard deviaion of Pakisan and India. The high sandard deviaion of APC of Pakisan and India suggess ha curren income in hese counries migh play an imporan role han permanen income while in China here is he possibiliy ha he permanen income may play he major role in heir individuals consumpion choices. The larger variaion in he Pakisan and India is due o he larger variaion in he growh rae of heir income. Therefore, modeling of consumpion for Pakisan and India is a demanding ask. b. Inferenial Saisics Firsly, he sudy ess he PIH for Pakisan, by esimaing he equaions (.6) and (.7). Table 3 presens he empirical resuls of equaion (.6) and equaion (.7). These equaions are esimaed by using OLS and insrumenal variables (IV) mehod. Equaion (.6) is esimaed by applying he OLS mehod; he resuls of equaion (.6) show he srong validiy of AIH for Pakisan. Therefore, consumpion follows curren income raher han permanen income. Boh OLS and IV mehods are used o esimae equaion

6 304 Pakisan Journal of Social Sciences Vol. 3, No. (.7). Model,, 3, 4, and 5 are esimaed by using he IV liss; firs, second, hird, fourh and fifh, offers by able. Table Liss of Insrumenal Variables Insrumenals Variables Liss which are Used in Empirical Esimaions Lis Insrumenals variables Firs lis y,..., y 6; r,..., r 6 c,..., c 6; r,..., r 6 y,..., y 6; c,... c 6; cy ; r,..., r 6 i,..., i 6; r,..., r 6 i,... i 6; y,..., y 6; c,... c 6; cy ; r,..., r y =growh rae of real GDP, r = discoun rae minus change in CPI, c i Second lis Third lis Fourh lis Fifh lis Noe: household consumpion, cy = log of MPC, and = growh rae of real = change in nominal ineres rae. The resuls of he equaion (.7) suppor he AIH for Pakisan. The high and significan values of marginal propensiy o consume (MPC) ensure he invalidiy of PIH and indicae ha he predicable changes in income revise consumpion decision of consumers in Pakisan. 6 Table 3 Esimaed Resuls of Equaion (.6) and (.7) Esimaors of equaions Models Insr: Lis α C = α + λ Y + ε C = µ + λ Y + σ. r + ε λ R DW µ λ σ R DW Model :(OLS) *** *** Model: (IV) *** Model: 3 (IV) *** Model: 4 (IV) *** Model: 5 (IV) *** Model: 6 (IV) *** Noe: Model one is esimaed wih he help of OLS mehod and model wo, hree, four, five and six are esimaed hrough SLS mehod, by using he insrumenal liss one, wo hree, four and five respecively. The coefficien on (**, ***) are saisically significan a he level of (5, ) percen respecively The sudy also esimaes equaion (.8) o highligh he reasons for he rejecion of he neoclassical consumpion hypohesis i.e. myopia and liquidiy consrains. Myopia violaes he PIH and implies ha consumers consume a consan fracion of heir curren income. While in liquidiy consrained consumers can smooh rising income hrough saving bu are unable o smooh falling income. The equaion (.8) clarifies he source of he rejecion of PIH. The esimaes of he equaion (.8) are repored in able 4. Equaion (.8) is esimaed wih he help of OLS and SLS by using he differen insrumenal variables, menioned in able. There are hree hypoheses regarding he equaion (.8). Firs, if he permanen income hypohesis is valid hen: λ = λ 0, =

7 Khalid Khan, Mohammed Nisha 305 second, if he PIH is no valid due o myopia hen he significan value of λ and λ will be: λ > 0, λ > 0 and λ = λ, and hird, if he PIH is no valid due o liquidiy consrains hen he significan value of λ and λ will be : λ > 0, and λ > λ. Table 4 Esimaed Resuls of Equaion (.8) Esimaors of equaions Models Insrumen Lis C = µ + λ( POS ) Y + λ ( NEG) Y + σ. r + ε µ λ λ σ F.saisics R H H 0 : λ = λ : λ λ = 0 0 DW Model: (OLS) E **.3 -.5E Model: (IV) 3.40E *** E ***.47 Model:3 (IV) -.E **.0 4.9E ***.47 Model: 4 (IV) 3.36E E-3** E ***.5 Model: 5 (IV) E-09.95E-3***.0.95E ***.47 Model: 6 (IV) 5 6.E E-3*** E ***.76 Noe: Model one is esimaed wih he help of OLS mehod and model wo, hree, four, five and six are esimaed hrough SLS mehod, by using he insrumenal liss one, wo hree, four and five respecively. The coefficien on (**, ***) are saisically significan a he level of (5, ) percen respecively Thus, he empirical resuls of able 3 shows ha he value of λ is negaive in model and posiive and significan in all IV models. While he value of λ is found insignifican in OLS and all remaining models. These resuls of equaion (.8) suppor he resuls of equaion (.6) and (.7) and rejec validiy of PIH because he possible condiion for he validiy of PIH is no found i.e. he expeced negaive and posiive income do no affec consumpion ( λ = λ = 0 ).The condiion which ensures myopia is also no observed in all models from o 6. Because he value of λ is insignifican in OLS model and hroughou he IV models. Furhermore, he resuls somehow fulfill he condiion of he liquidiy consrains i.e. λ is posiive, significan and greaer han zero. Furhermore, he resuls of equaion (.8) indicae ha consumpion is more sensiive o increases han decreases in predicable income, due o he significan values of λ and he insignifican values ofλ. As a resul of his evidence he presence of liquidiy consrains is ensured raher han myopia or perverse asymmery. Therefore, we can say ha he rejecion of PIH in Pakisan is no subjec o myopia bu liquidiy consrains. IV. Conclusion The sudy invesigaes validiy of he PIH in Pakisan. The resuls indicae invalidiy of PIH in Pakisan because he predicable changes in income can affec consumpion. This is he clear violaion of he neoclassical consumpion hypohesis. Furhermore, o find ou he reasons of he rejecion of he PIH, he sudy applies Shea (995) model o invesigae he reasons of rejecion of he PIH i.e. Myopia and liquidiy

8 306 Pakisan Journal of Social Sciences Vol. 3, No. consrain. The resuls are suppored by he presence of liquidiy consrains raher han myopia and perverse asymmery. Hall s model rejeced he PIH for Pakisan, while he Campbell and Mankiw (990) consumpion model shows ha small fracion of individuals suppor PIH in Pakisan. So, he asymmery responses in consumpion o he expeced income sugges ha he reason for he rejecion of PIH in Pakisan is he liquidiy consrain. References Bernanke, B. S. (985). Adjusmen Coss, Durables and Aggregae Consumpion. Journal of Moneary Economics, 5, Campbell, J. and Mankiw, N. (990). Permanen Income, Curren Income, and Consumpion. Journal of Business and Economic Saisics, 8, Duesenberry, J. S. (948). Income Saving and he Theory of Consumpion Behavior. Cambridge: Harvard Universiy Press, 948 Flavin, M. A. (98). The Adjusmen of Consumpion o Changing Expecaion abou Fuure Income. Journal of Poliical Economy, 89, Flavin, M. (985). Excess sensiiviy of consumpion o curren income: Liquidiy consrains or myopia. Canadian Journal of Economics, 8, Friedman, M. (957). A heory of he consumpion funcion. Princeon Universiy Press. Paz, L. (006). Consumpion in Brazil: myopia or liquidiy consrains: A simple es using quarerly daa. Applied Economic Leers,, Gomes and Paz (00). Consumpion in Souh America: myopia or liquidiy consrains? Economia Aplicada, 4, Jappelli, T. & Pagano, M. (989). Consumpion and capial marke imperfecions: An inernaional comparison. American Economic Review, 79, Hall, E. E. (978). Sochasic Implicaions of he Life Cycle-Permanen Income Hypohesis: Theory and Evidence. Journal of Poliical Economy, 86, Hayashi, F., (98). The Permanen income Hypohesis: Esimaion and Tesing by Insrumenal Variables. Journal of Poliical Economy, 90, Khalid, A. M. (994). Empirical Tes of he Raional Expecaion and Permanen Income Hypohesis Evidence from Pakisan. The Pakisan Developmen Review, 33, Kuznes, S. (946) Naional produc since 869 (assised by L. Epseion and E. Zanks), New York, Naional Bureau of economics research.

9 Khalid Khan, Mohammed Nisha 307 Lucase, R. E. J. (976). Economeric Policy Evaluaion: A Criique. Carnegie-Rocheser Conferences on Public policy,, Modigliani, F. and Brumberg, R. E., (954). Uiliy Analysis and Aggregae Consumpion Funcion: An Inerpreaion of Cross Secion Daa. In Pos Keynesian Economics, K.K Kurinara (ed) New Bruns Wick: Rugers Universiy Press. Runkle, D. (99). Liquidiy Consrains and he Permanen Income Hypohesis. Journal of Moneary Economics, 7, Shea, J. (995). Myopia, Liquidiy Consrains, and Aggregae Consumpion: A simple Tes. Journal of Money, Credi and Banking, 7, Zeldes.S.P. (989). Consumpion and Liquidiy Consrains: An Empirical Invesigaion. Journal of Poliical Economy, 97,