Question

Using applicable models, do a critical analysis of permanent income hypothesis and random walk models and the difference between the two model

Answer 1

The permanent Income Hypothesis is a theory of consumer spending stating that people will spend money at a level consistent with their expected long term average income. The level of expected long term income then becomes tough of as the level of permanent income that can be safely spent. A worker will save only if his or her current incon=me is higher than the aniticipated level of permanent income , in order to guard against future declines in income.

The random walk model implies that future consumption changes are totally unperdictable. So no matter what information you have available, you cannot predict future consumption.

Permanent income hypothesis says that consumers should respond little to transitory income but should respond a lot to permanent income. if income rises today you just want to consume it today, you want to consume it in future as well. But in case of a random walk model a stronger claim has been maid that actuallu consumption tommorow is forecastable today and there will not be precautionary savings. the reason precautionary savings is not considered is due to the utility function for which marginal utility is lenear and thus we don't get lprecautionary savings.