This document outlines the methodology for testing different consumption hypotheses in Pakistan, including the Absolute Income Hypothesis, Relative Income Hypothesis, Permanent Income Hypothesis, and Life Cycle Income Hypothesis. It discusses previous literature on consumption functions and different approaches for estimating consumption, such as Hall's random walk model and the Campbell and Mankiw consumption model. The methodology section describes using an Euler equation approach and consumption data from national accounts and household surveys to test the hypotheses at the macro level, micro level, and for urban vs. rural households.

1. Essay on Consumption
Hypotheses
Khalid Khan
Lasbela University of Agriculture, Water and
Marine Sciences, Uthal, Lasbela, Balochistan

2. Outline of Presentation
 INTRODUCTION
 Background of the Study
 Statement of the Problem
 Significance of the Study
 LITERATURE REVIEW
 METHODOLOGY
 DATA

3. Introduction
 Background of the Study
According to the simple Keynesian
consumption function, consumption
depends solely on disposable
income in the current period.
However, it does not consider
individuals’ expected income or and
time preference for consumption.

4. Introduction
Therefore, there are contradictions
between the simple Keynesian
consumption function and empirical
evidence. Friedman’s permanent income
hypothesis (PIH) takes into account
lifetime income and is more general and
better than the Keynesian absolute
income hypothesis (AIH). Many
economists treat PIH and Life Cycle
Hypothesis (LCH) equal.

5. Introduction
 Statement of the Problem
Absolute Income Hypothesis
Relative Income Hypothesis
Permanent Income Hypothesis
Life Cycle Income Hypothesis
So, it is important for policy makers
that what type of hypothesis is
consistent with Pakistan

6. Introduction
 Significances of the Study
 Consumption expenditure accounts
for approximately sixty percent of
GDP in Pakistan.
 Critical determinant of aggregate
demand.
 Consumption is less volatile than
investment.

7. Introduction
 Help us in the understanding of
business cycle, and second, it is the
basic determinant of economic
welfare
 Counterpart of consumption is
saving

8. Literature Review
 The psychological law of
consumption generally known as
absolute income hypothesis (AIH)
introduced by Keynes (1936)
 Kuznets (1946) empirical puzzle.
 Duesenberry (1948) relative income
hypothesis (RIH).
 Friedman (1957) Permanent Income
Hypothesis s

9. Literature Review
 Modigliani and Brumbergh (1954) Life
Cycle Income Hypothesis.
 Hall (1978) developed new approach to
test consumption hypothesis, he took life
cycle permanent income hypothesis and
applied rational expectation and he
conclude that current consumption is
sufficient for estimation of future
consumption.

10. Literature Review
 Flavin (1981) tested the Hall REH by
simple structural econometric model of
consumption.
 Campbell and Mankiw (1989) test the PIH
they find that about fifty percent of
individual’s consumption choices are
based on the PIH while the remaining
individual’s consumption choices are
based on their current income.

11. Literature Review
 Hsich et al. (1994) tested the PIH and AIH
for four Asian countries (Korea, Taiwan,
Thailand, and India)
 Shea (1995) tested the life cycle
permanent income hypothesis for U.S
economy
 Drakos et al. (2002) investigated that the
aggregate consumption in Greece used
the aggregate data of consumption

12. Literature Review
 Manitsaris (2006) using annual data
of fifteen European Union countries
and estimate consumption function
under the PIH.
 Dejuan et al. (2006) tested the PIH
for 11 states of West German.
 Liu et al. (2007) tested PIH with
Hong Kong’s consumption data from
1984 to 2006

13. Methodology
 There are several ways through which we
estimate the consumption function. But
the standard model is Euler equation
approach. The pioneer of testing the PIH
under the rational expectation with Euler
equation was Hall (1978). Friedman
(1947) estimated the permanent income
by using the distributive lag of current
income. Lucase (1976) postulates that the
lags of current income did not explained
the current consumption

14. Methodology
 In the response to Lucase (1976) critique,
Hall (1978) showed that with out current
consumption other variable have no
explanatory power to forecast future
consumption
 HALL’S RANDOM WALK MODE
According to PIH, it is usually assumed
that aggregate consumption represents
the individual decision, so the
representative individual maximizes

15. Methodology

16. Methodology

17. Methodology
With the help of above equation (5)
we will test the permanent and
income hypothesis and Absolute
income hypothesis for Pakistan,
simultaneously.

18. Methodology
Campbell and Mankiw (1990)
Consumption Model
This model assumes that the
proportion of (1-k) individuals are
forward looking and satisfy the PIH
while a proportion of ( k) follow the
“rule of thumb” and consume their
current income.

19. Structure of Estimations
 Testing AIH and PIH at Macro level
 Testing AIH and PIH at Micro level
 Testing AIH and PIH for Urban
Households and Rural Households

20. Sources of Data
The data of the following variables are
extracted from the international financial
statistics and Household
Integrated Economic
Survey (HIES)
 Private consumption
 Income( GDP)
 Real interest rate
 Individual’s income
 Individual's consumption

21. Thanks