Random Walk Hypothesis

The neoclassical permanent-income and life-cycle model leads to a counterintuitive

conclusion. The shape of a consumer’s time path of consumption should be independent
of the shape of his or her time path of income. This independence of consumption
changes from expected changes in income is known as the random-walk hypothesis
of consumption.
The random-walk hypothesis is not a separate theory but rather an implication of the
neoclassical model. It was first explored in a study by Hall (1978). Hall’s random walk
hypothesis combines the permanent income hypothesis with the assumption that
consumers have rational expectations about future income. It implies that changes in
consumption are unpredictable because consumers change their consumption only when
they receive news about their life time resources. He tested the stochastic implications of
the Life cycle Permanente income hypothesis with time series data for the post war
United States. The finding is consistent with a modification of the hypothesis that
recognizes a brief lag between changes in permanent income and the corresponding
changes in consumption. Thus the evidence supports a modified version of the Life
cycle permanent income hypothesis.
Whether the amount of consumption changes due to a given unexpected income change
is consistent with the amount predicted by the life cycle-permanent income model is
studied by Flavin (1993) by examining the average degree to which unexpected changes
in income affected lifetime income, then relating the change in consumption to the
change in expected lifetime income. She found substantial evidence of excess sensitivity
of consumption to current changes in income. Changes in income seemed to cause
consumption to change by more than would be consistent with the average amount of
change in lifetime income that should result.
 Normal Income Hypothesis:

We have seen that as a result of the efforts of Milton Friedman, Modigliani, Ando,
Brumberg new theories of consumption function have been developed. M.J. Farrell
explains the normal income hypothesis on the basis of the work done by these gentlemen.
Farrell’s main point of departure from

Friedman’s PIH is with respect to the time span taken into consideration. The basis
of his theory is the recognition that, if an individual plans rationality to maximize his
utility over his life-time, his consumption in any given year will depend, not on his
income alone in that year, but on the resources of which he disposes off during his life-
time.

If an individual knows with certainty his future stream of earnings, and there is a
perfect capital market with a given rate of interest—it is possible to know the resources
of which he disposes. It is known by the current value (represented by v) of his current
assets plus his expected future earnings (discounted at the rate of interest).

While defining the earnings, Farrell includes in it all receipts except the interest
yield of assets if the individual expects a constant annual income Y for the remainder of
his life span and Y is such that the current value of this income stream is just equal to v,
then Y may be called individual’s normal income. If such an individual also knows his
future tastes and future course of prices, and plans his consumption so as to maximize his
satisfaction over his life-time, his planned consumption in each year will be uniquely
determined by his normal income Y. Thus, the normal income hypothesis states, that in
any given period, an individual’s current income affects his consumption only through its
effect on his normal income Y.
We may write this relationship between this consumption expenditure and normal
income as follows:
C = β (Y)

where β is independent of current income and assets.

However, in actual practice, a perfect capital market as assumed by the theory is

not possible and thus raises a number of theoretical difficulties—notably that it is not
clear at what rate to discount future earnings and also how can a consumer has perfect
knowledge of his income in the remainder of his life-time. The very fact that we live in
an uncertain world is a source of much greater difficulties. Rational behaviours in the
phase of uncertainty is a problem that has not yet been solved.

Farrell points out that there are various possible reasons because of which there is
little possibility of the current income influencing directly current consumption—firstly
because, there is uncertainty about future which might lead people to spend every penny
that they have; but this might be confined to small minority, because persons who have
positive savings or assets are unlikely to spend them simply because the future is
uncertain.

Thus, it is just possible that current income might not directly influence current
consumption as thought by Farrell. Secondly, it is just possible that people on account of
uncertainty may abandon the maximizing calculation in favour of certain conventions
about saving. Thus, it could be concluded that the rational consumption behaviour
conforms to normal income hypothesis particularly when the incomes are more variable.
This has been proved by empirical tests.
 Drift Hypothesis

One of the first attempts to reconcile the short run and long run consumption
function was under taken by Arthur Smithies (later James Tobin). He suggested that
consumption function drifts upward over time. The drift hypothesis argues that basic
relation is non-proportional but in the long run it becomes proportional due to upward
shift in the basic non-proportional as a result of change in factors other than income.
Several factors could be responsible in the upward shift in the consumption function.
They are rural-urban migration, redistribution of income, product improvement,
credit expansion and social insurance.

On the first attempts to reconcile the short run and long run consumption functions was
by Arhur Smithies and James Tobin. They tested Keynes absolute income hypothesis in
separate studies and came to the conclusion that the short run relationship between
consumption and income is non-proportional but the time series data show the long run
relationship to be proportional.

The latter consumption income behaviour results through an upward shift or drift in
the short run non proportional consumption function due to factors other than income.
Smithies and Tobin discuss the following factors:

1. Asset Holdings

Tobin introduced asset holdings in the budget studies of negro and white families
to test this hypothesis. He came to the conclusion that the increase in the asset
holdings of families tends to increase their propensity to consume thereby leading
to an upward shift in their consumption function.

2. New Products
 Since the end of the second world war, a variety of new household consumer
goods have come into existence at a rapid rate. The introduction of new products
tends to shift the consumption function upward.

3. Urbanisation

Since the post world war there has been an increased tendency toward
urbanisation. This movement of population from rural to urban areas has tended to
shift the consumption function upward for the reason that the propensity to
consume of the urban wage earners is higher than that of the farm workers.

4. Age Distribution

There has been a continuous increase in the percentage of old people in the total
population over the long run. Though the old people do not earn but they consume
commodities. Consequently, the increase in their numbers has tended to shift the
consumption function upward.

5. Decline in Saving Motive

The growth of social security system makes automatic saving and guarantees
income during illness. Redundancy disability and old age has increased the
propensity to consume.

6. Consumer Credit

The increasing availability and convenience of short term consumer credit shifts
the consumption function upward. The greater case of buying consumer goods
with credit cards, debit cards, use of ATMs and cheques and availability of
instalment buying causes an upward shift in the consumption function.

7. Expectation of income increasing

 Average real wages of workers have increased and they expect them to rise in the
future. These cause an upward shift in the consumption function. Those who
expect higher future earnings tend to reduce their savings or even borrow to
increase their present consumption.

The consumption drift theory is explained in the diagram 3 where CL is the long
run consumption function which shows the proportional relationship between
consumption and income as we move along it. CS1 and CS2 are the short run
consumption functions which cut the long run consumption function CL at points A and
B. but due to the factors mentioned above, they tend to drift upward from point A to
point B along the curve CL curve.

Each point such as A and B on the CL curve represents an average of all the
values of factors included in the corresponding short run functions, CS1 and CS2
respectively and long run function, CL connecting all the average values. But the
movement along the dotted portion of the short run consumption functions, CS1
and CS2 would cause consumption not to increase in proportion to the increase in
income.

Its Criticisms
The great merit of this theory is that it lays stress on factors other than in income which
affect the consumer behaviour. In this sense, it represents a major advance in the theory
of the consumption function. However it has its short comings.

1. The theory does not tell the rate of upward drift along the CL curve. It appears to
be a matter of chance.

2. It is just a coincidence if the factors explained above cause the consumption

function to increase proportionately with increase in income so that the average of
the values in the short run consumption function equals a fixed proportion of
income.

3. According to Duesenberry all the factors mentioned as causes of the upward shift
are not likely to have sufficient force to change the consumption savings
relationship to such an extent as to cause the drift.

4. Duesenberry also points out that many of the factors such as decline in saving
motive would lead to a secular fall in the consumption function. Such saving plans
as life insurance and pension programs tend to increase savings and decrease the
consumption function. Moreover, people want more supplementary savings to
meet post retirement needs which tend to decrease their current consumption.