Dundee Discussion Papers in Economics 138:The life-cycle-permanent-income model: a reinterpretation and evidence

It is generally agreed that the consumption path implied by the standard stochastic life-cycle version of the permanent-income model is a random walk. The failure of the latter to conform to data, however, undermines the suitability of the underlying theoretical framework. We propose an alternative way of solving for the consumption path by reinterpreting Friedman’s revision rule and show that the resulting path is compatible with the solution to a life-cycle optimising problem with habit formation and precautionary saving motives. Evidence, obtained by applying the Kalman filter to U.S. data for 1929-2001, strongly supports the proposed approach