Random walk model of consumption

The random walk model of consumptionwas introduced by economist Robert Hall.[1] This model uses the Euler equation to model consumption. He created his
consumption theory in response to the Lucas critique. Using Euler equations to model the random walk of consumption has become the dominant approach to
modeling consumption.[2]

Contents
Background
Theory
Model
Implications
Advantages
Criticisms
References

Background
Hall introduced his famous random walk model of consumption in 1978.[3] His approach is differentiated from earlier theories by the introduction of the Lucas
critique to modeling consumption. He incorporated the idea of rational expectations into his consumption models and sets up the model so that consumers will
maximize their utility.

Theory
Robert Hall was the first to derive the effects of rational expectations for consumption. His theory states that if Milton Friedman’s permanent income hypothesisis
correct, which in short says current income should be viewed as the sum of permanent income and transitory income and that consumption depends primarily on
permanent income. Hall’s theory says that if that’s true and if consumers have rational expectations then any changes in consumption should be unpredictable i.e.
follow a random walk. Hall’s thoughts were: According to the permanent-income hypothesis consumers deal with shifting income and try to smooth their
consumption over time. At any given moment a consumer selects their consumption based on their current expectations of their lifetime income. Throughout their
life consumers modify their consumption because they receive new information that makes them adjust their expectations. For example, a consumer receives an
unexpected promotion at work increases consumption. Whereas a consumer that is unexpectedly fired or demoted will decrease consumption. So changes in
consumption reflect “surprises” about lifetime income. If consumers are optimally using all available information, then they should be surprised only by events
that were completely unpredictable. Therefore, consumer [4][5]
’s changes in consumption should be unpredictable as well.

Model
Consider a two-period case. The Euler equation for this model is

(1)

where is the subjective time preference rate, is the constant interest rate, and is the conditional expectation at time period 1.

Assuming that the utility function is quadratic and , equation (1) will yield

(2)

Applying the definition of expectations to equation 2)

( will give:

(3)

where is the innovation term. Equation (3) suggests that consumption is a random walk because consumption is a function of only consumption from the
previous period plus the innovation term.
Implications
Robert Hall’s rational expectation approach to consumption creates implications for forecasting and analyzing economic policies. “If consumers obey the
permanent-income hypothesis and have rational expectations, then only unexpected policy changes influence consumption. These policy changes take effect when
they change expectations.” [6] Though the policy changes affect consumption only as much as they affect permanent income. Furthermore, only new information
about policies can affect permanent income.[7] This model implies that changes in consumption are unpredictable because consumers change their consumption
only when they receive news about their lifetime resources.

Advantages
Use of the Euler equations to estimate consumption appears to have advantages over traditional models. First, using Euler equations is simpler than conventional
[8]
methods. This avoids the need to solve the consumer's optimization problem and is the most appealing element of using Euler equations to some economists.

Criticisms
Controversy has arisen over using Euler equations to model consumption. When applying the Euler consumption equations one has trouble explaining empirical
data.[9][10] Attempting to use the Euler equations to model consumption in the United States has led some economists to reject the random walk hypothesis.[11]
[12]
Some argue that this is due to the model's inabilityto uncover consumer preference variables such as the intertemporal elasticity of substitution.

References
1. Hall (1978)
2. Chao, Hsiang-Ke (2007). "A Structure of the Consumption Function".Journal of Economic Methodology. 14 (2): 227–248.
doi:10.1080/13501780701394102(https://doi.org/10.1080%2F13501780701394102) .
3. Hall, Robert (1978). "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence".
Journal of Political
Economy. 86 (6): 971–987. doi:10.1086/260724 (https://doi.org/10.1086%2F260724). JSTOR 1840393 (https://www.jstor.org/stable/1840393).
4. Hall, Robert (1978). "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence".
Journal of Political
Economy. 86 (6): 971–987. doi:10.1086/260724 (https://doi.org/10.1086%2F260724). JSTOR 1840393 (https://www.jstor.org/stable/1840393).
5. Mankiw, N. Gregory (2016). "Robert Hall Random-Walk Hypothesis". Macroeconomics (9): 475–503.
6. Mankiw, N. Gregory (2016). "Robert Hall Random-Walk Hypothesis". Macroeconomics (9): 475–503.
7. Hall, Robert (1978). "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence".
Journal of Political
Economy. 86 (6): 971–987. doi:10.1086/260724 (https://doi.org/10.1086%2F260724). JSTOR 1840393 (https://www.jstor.org/stable/1840393).
8. Attanasio, Orazio; Low, Hamish. "Estimating Euler Equations". Review of Economic Dynamics. 7: 405–435. doi:10.1016/j.red.2003.09.003(http
s://doi.org/10.1016%2Fj.red.2003.09.003).
9. Molana, H. (1991). "The Time Series Consumption Function: Error Correction, Random W
alk and the Steady-State".The Economic Journal.
101 (406): 382–403. doi:10.2307/2233547 (https://doi.org/10.2307%2F2233547). JSTOR 2233547 (https://www.jstor.org/stable/2233547).
10. Canzoneri, M. B.; Cumby, R. E.; Diba, B. T. (2007). "Euler equations and money market in
terest rates: A challenge for monetary policy models".
Journal of Monetary Economics. 54 (7): 1863. doi:10.1016/j.jmoneco.2006.09.001(https://doi.org/10.1016%2Fj.jmoneco.2006.09.001) .
11. Jaeger, Albert (1992). "Does Consumption T ake a Random Walk?". The Review of Economics and Statistics. 74 (4): 607–614.
doi:10.2307/2109374 (https://doi.org/10.2307%2F2109374).
12. Carroll, Christopher D. (2001). "Death to the Log-Linearized Consumption Euler Equation! (Andery
V Poor Health to the Second-Order
Approximation)". Advances in Macroeconomics. 1 (1).

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