The Dynamic Effects of Permanent and Transitory Labor Income on Consumption

Barry Falk and Bong-Soo Lee

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This paper develops a version of the Permanent Income Hypothesis in which permanent and transitory components of consumption and labor income are explicitly accounted for. The model is used to derive a restricted vector autoregressive representation of adjusted measures of consumption and saving, which is used to test the theory and to study the dynamic effects of the two • components of labor income on consumption. We find that the restrictions on the VAR are not easily rejected for quarterly post-war U.S. data. An analysis of the restricted VAR leads us to conclude that consumption can be almost entirely explained in terms of the permanent component of labor income.

Date: 1991-02-01
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