Research Discussion Paper – RDP 8808 Consumption and Permanent Income: The Australian Case


The sharemarket crash of October 1987 has raised the question of the effect of a change in share prices on real consumption expenditure. This paper examines this issue by examining the role of permanent income or wealth in explaining the behaviour of aggregate consumption expenditure in Australia. Two approaches to testing the permanent income hypothesis are used. The first applies extensions to the method proposed by Hall (1978) and the second follows Hayashi (1981). Both approaches, using a variety of tests, give strong support for the permanent income hypothesis. In testing the relative explanatory power of permanent versus current income, we find that between 50 per cent and 70 per cent of consumption expenditure is consistent with the permanent income hypothesis and the remainder is explained by current income.

It is argued in the paper that although consumption expenditure seemed unaffected by the sharemarket crash, this outcome is still consistent with the permanent income hypothesis.

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