Testing the Implications of the Permanent Income Hypothesis in Sweden

2 The purpose of this thesis is to test the implications of the permanent income – life cycle hypothesis. According to Hall (1978), if the permanent income-life cycle hypothesis is valid, consumption should follow a random walk and no variable other than once-lagged consumption should help explaining current consumption. Two different tests are conducted. Firstly, consumption is regressed upon its one-period lag and various other lagged variables. Secondly, following the method proposed by Campbell and Mankiw (1990), the alternative that consumption follows a random walk is tested by identifying the fraction of disposable income, rather than permanent income, that is consumed. Both tests reject the permanent income – life cycle hypothesis. In addition, the last part of this thesis shows that consumption is cointegrated with wealth and income which implies a long-run relationship between these variables. A short-run model i