PATTERNS OF HOUSEHOLD CONSUMPTION IN VIETNAM

Website: Email : Tel (: 0918.775.368

NATIONAL ECONOMIC UNIVERSITY INSTITUTE OF SOCIAL STUDY
HA NOI THE HAGUE
VIETNAM – NETHERLANDS PROJECT FOR MASTER DEGREE ON
ECONOMICS OF DEVELOPMENT
PATTERNS OF HOUSEHOLD CONSUMPTION
IN VIETNAM
A thesis presented by
Cao Thi Thuy Hang
Supervisor
Dr. NGO HUY DUC
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR OBTAINING
THE DEGREE OF
MASTER OF ARTS IN ECONOMICS OF DEVELOPMENT
Hanoi, 2006
ACKNOWLEDGEMENTS
First of all, I would like to thanks the Vietnam-Netherlands project for providing me the opportunity to
participate in this course, in which I have received many benefits in terms of knowledge, approach and
methodology of doing research.
I wish to express my since thanks to my supervisor, Dr. Ngo Huy Duc for his patient attention,
guidance and precious advice. His assistance helped me overcome difficulties and encourage me during
the period of writing this thesis.
I am indebted to Dr. Adam Mc.Carty and Prof., Dr.Sc. Vu Thieu for their efforts in running the Project
and their strict disciplines toward writing a thesis. Their advice would still accompany with my life and
my career in the future.
My thanks are also sent to all my teachers in the Vietnam-Netherlands Project for Master Program in
Economics of Development for their enthusiastic supports.
I also wish to express my appreciation for the assistance of the project staffs; all my friends and
classmates who helped me fulfill this thesis
Finally, I would like to thank my family for their understanding and support during the thesis

preparation process.
ii
TABLE OF CONTENTS
CHAPTER 1: INTRODUCTION................................................................................................1
1.1 The relevance of the thesis...............................................................................................1
1.2 Focus and scope of the thesis...........................................................................................2
1.3 Methodology.....................................................................................................................3
1.4 Data sources.....................................................................................................................3
1.5 Structure of the thesis......................................................................................................3
CHAPTER 2: THEORETICAL FRAMEWORK......................................................................5
2.1 Concepts and definitions..................................................................................................5
2.1.1 Household..........................................................................................................................5
2.1.2 Consumption......................................................................................................................6
2.2 Consumption theories......................................................................................................6
2.2.1 Keynes’ consumption function....................................................................................6
2.2.2 Fisher’s intertemporal choice model............................................................................8
2.2.3 Modigliani’s life-cycle hypothesis.............................................................................10
2.2.4 Friedman’s permanent-income hypothesis................................................................13
2.2.5 Hall’s random-walk hypothesis.................................................................................15
2.3 Empirical study review..................................................................................................16
2.4 Chapter remarks............................................................................................................18
iii
CHAPTER 3: AN OVERVIEW OF HOUSEHOLD CONSUMPTION IN VIETNAM........20
3.1 Characteristics of household in Vietnam......................................................................20
3.2 Household consumption in Vietnam in 2002................................................................21
3.2.1 Household consumption by household income..........................................................21
3.2.2 Household consumption by region and quintiles.......................................................22
3.2.3 Household consumption between urban and rural area..............................................24
3.2.4 Household consumption by household size and number of children.........................25
3.2.5 Household consumption by household head’s education ..........................................26

3.2.6 Household consumption and head’s age and gender..................................................27
3.2.7 Household consumption by occupation of household head ......................................29
3.3 Chapter remarks...............................................................................................................29
CHAPTER 4: MODEL SPECIFICATION AND EMPIRICAL RESULTS.................31
4.1 Model specification........................................................................................................31
4.1.1 Econometric formulation...........................................................................................31
4.1.2 Variables....................................................................................................................32
4.1.2.1 Dependent variable.......................................................................................32
4.1.2.2 Explanatory variables...................................................................................32
4.2 Data and estimation procedure.....................................................................................36
4.2.1 Data description.........................................................................................................36
4.2.2 Estimation procedure.................................................................................................39
iv
4.3 Estimation results...........................................................................................................39
4.4 Chapter remarks............................................................................................................44
CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS...................................45
5.1 Conclusions.....................................................................................................................45
5.2 Recommendations..........................................................................................................46
5.3 Limitations and suggestion for further studies............................................................47
Bibliography................................................................................................................................48
Appendix.....................................................................................................................................51
v
LIST OF TABLES
Table 3.1: Household consumption and HH income by quintiles (’000 VND/year)........................22
Table 3.2: Household consumption by regions and quintiles (’000 VND/year)...............................23
Table 3.3: Household consumption by rural/urban and consumption quintiles (’000 VND/year)....24
Table 3.4: Household head’s number of schooling year by consumption quintiles..........................27
Table 3.5: Age of household head by consumption quintiles...........................................................27
Table 3.6: Household consumption by head’s gender and consumption quintiles
(’000 VND/year)..............................................................................................................................28

Table 3.7: Household consumption by occupation of household head and consumption quintiles (’000
VND/year).......................................................................................................................................29
Table 4.1: Variables description.......................................................................................................38
Table 4.2: Estimation of household consumption in Vietnam in 2002.............................................40
vi
LIST OF FIGURES
Figure 1.1: Keynes’ consumption function.....................................................................................7
Figure 1.2: The consumer’s budget constraint..............................................................................10
Figure 1.3: The life-cycle hypothesis of consumption..................................................................11
Figure 1.4: The Life-cycle consumption functions........................................................................12
Figure 1.5: Household consumption and permanent income.........................................................15
vii
LIST OF APPENDIXES
Appendix 3.1: Household consumption by number of schooling year..........................................51
Appendix 3.2: Household consumption by household size...........................................................52
Appendix 3.3: Household consumption by number of children....................................................53
Appendix 4.1: Regions classification in the data set.....................................................................54
Appendix 4.2: Urban and rural classification ...............................................................................55
Appendix 4.3: Variable definition.................................................................................................56
Appendix 4.4: Estimation of full model........................................................................................57
Appendix 4.5: Estimation of reduced model.................................................................................58
Appendix 4.6: Analysis of correlation among variable.................................................................59
Appendix 4.7: Test normality of residual .....................................................................................60
Appendix 4.8: Other usual tests ...................................................................................................61
viii
ABBREVIATIONS
ADB Asian Development Bank
APC Average propensity to consume
CPI Consumer Price Index
GDP Gross Domestic Product

GNP Gross National Product
GSO General Statistic Office
LCH Life-cycle hypothesis
MPC Marginal propensity to consume
MSE Residual Mean Square
OLS Ordinary Least Square
PIH Permanent income hypothesis
P-|t| Associated p-value
SOE State-owned enterprise
Std.Dev. Standard Deviation
UNDP United Nations Development Program
VHLSS Vietnam Household Living Standard Survey
VLSS Vietnam Living Standard Survey
VND Vietnamese Dong
WB World Bank
ix
CHAPTER 1
INTRODUCTION
“Consumption is the sole end and purpose of all production”
- Adam Smith -
1.1 THE RELEVANCE OF THE THESIS
In any society, one of the ultimate objectives of the economic system is to deliver goods and services to
its members. The success of an economy can be measured by its ability to provide for its people, to feed
them, to clothe and shelter them, and to offer them access to good health, to education and to a wide
range of consumer goods (Deaton and Case, 1987). Based on such things, to evaluate the prosperity and
social welfare of an economy, consumption is the most appropriate measurement.
At macro level, consumption, or more precisely aggregate consumption, is a major component of
aggregate demand or so-called gross national product (GNP). It runs about 65 percent of GNP in the
United States (Branson, 1989) and even higher in many developing counties, accounted for about three
fourth of annual GNP (Deaton, 1997). Because of its significance, consumption becomes direct or

indirect target of many economic polices such as demand stimulating policy, other fiscal policies and
national programs.
With respect to consumer behavior at micro level, household consumption is also of interest. Patterns of
consumption within the budget constrain are important in examining the structure of household activity,
while the amounts consumed of various goods, particularly foodstuffs, are usually used in determining
nutritional status, health and life-expectancy, which in turn results in the quality and quantity of human
resource in the economy.
Considered to be one of the most successful economies in transition, Vietnam has experienced high
growth rate of about 8 percent annually (GSO, 1998). Consequently, a large number of poor household
have been escaped from poverty and living standard has much improved. A decade ago, 58 percent of
the population had an expenditure level that was insufficient to support a healthy life but this figure had
fallen to 29 percent by 2002 (Rama, 2004).
1
To measure of these changes in Vietnamese living standards, consumption is used extensively and
taken an important component of human welfare. In much of the World Bank’s operational work as
well as in applied research, consumption constructed from survey data have been used to measure
poverty, to analyze changes in living standards over time, and to assess the distributional impacts of
various programs and policies in Vietnam.
Although there were a great number of researches attempting to analyze and evaluate different aspects
of poverty in Vietnam by using VLSS 1992 and VLSS 1998 data sets, less work has been done on
household consumption. Moreover, the limited accuracy of data on consumption from VLSS 1992 and
VLSS 1998 has hindered researchers’ endeavors in studying on household consumption composition, as
well as its determinants.
For those reasons, basing on an accurate data set, VHLSS 2002, to find out determinants of household
consumption is worth of researching. Beyond the analysis of household consumption, a foundation for
proposing policies on consumption stimulation established. It is particularly relevant to developing
countries like Vietnam of which consumption occupies a large share of aggregate demand.
1.2 FOCUS AND SCOPE OF THE THESIS
This thesis focuses on the demand side of the household consumption, of which household expenditure
is an official proxy. Main purpose of this paper is investigating determinants of household consumption.

Other factors in supply side including price, inflation, and supply quantity will be neglected.
The thesis also tries to examine fixed effects of household characteristics on consumption level rather
than random effects. Applied model is an expansion of fundamental macroeconomic consumption
model introduced by Keynes.
Major objective of the thesis is finding out the answer to the central question: “What are determinants
of household consumption in Vietnam?”
Sub questions:
• To what extent and in what dimension does the household characteristics affect to
consumption?
2
• Is there any geographic effect on patterns of household consumption?
• What are implications for consumption stimulating and development policy?
1.3 METHODOLOGY
The study is developed in analytical framework from demand side of consumption. This thesis will
firstly review fundamental theoretical issues relating to household consumption. Then, it will
concentrate on descriptive analysis of household consumption relying on data from VHLSS 2002. A
quantitative analysis using linear econometric model will be applied to demonstrate main characteristics
of household affecting to the household consumption level. Finally, it will show key findings and
suggest some policy implications for enhancing household consumption in Vietnam.
1.4 DATA SOURCES
For primary analysis, relying data is Vietnam Household Living Standard Survey (VHLSS) carried out
by the General Statistic Office (GSO) in 2002. The nation-wide household survey was part of the
Living Standards Measurement Study (LSMS) household surveys with technical assistance from the
World Bank. It is cross sectional in design and administered at the individual level with nearly 140,000
observations. However, the number of observation at household level is only nearly 30,000.
The VHLSS 2002 used questionnaires contained 9 sections each of which covered a separate aspect of
household activities. Those are: (i) Household member; (ii) Education; (iii) Employment; (iv) Health;
(v) Income and Source of income; (vi) Expenditure; (vii) Fixed assets and durable things; (viii)
Housing; (iv) Participant in poverty alleviation program. The whole data set is recorded in STATA data
files. Those files include data about household size, age, sex, education, occupation, expenditure,

income, and other household compositions and geographic features that are available for studying.
1.5 STRUCTURE OF THE THESIS
The thesis includes five chapters. After the introduction, chapter 2 provides key concepts, and general
theoretical framework on household consumption. This chapter firstly reviews fundamental
3
consumption theories, which show numerous approaches explaining consumption behavior of
household. Then, it goes over key findings of some relevant empirical studies on the aspect.
An overview of household consumption in Vietnam relying on data set VHLSS 2002 is presented in
chapter 3. This chapter points out intuitive patterns of household consumption in Vietnam with
descriptive tendency and expectations before coming to quantitative analysis.
The core part of the thesis is chapter 4, which focus on quantitative analysis of household consumption
including highlighting major features of household consumption, rationing and formulating
econometric model, describing data, presenting and interpreting empirical results.
Based on chapter 3 and chapter 4, Chapter 5 is dedicated to key findings and proposing some policy
implications.
4
CHAPTER 2
THEORETICAL FRAMEWORK
This chapter is dedicated to discussing theoretical framework and empirical studies on household
consumption. Some basic concepts and definitions will be presented in the first section of this chapter.
The second section will concentrate on the evolution of theories on consumption. The third section is
devoted to reviewing some outstanding empirical studies on household consumption.
2.1 CONCEPTS AND DEFINITIONS
2.1.1 Household
The concept of household is defined and discussed by economists, feminists, and anthropologists. Chen
and Dunn (1996) defined household as a domestic residential group whose members live together in
intimate contact, rear children, share the proceeds of labor and other resources held in common, and in
general cooperate on a day-to-day basis. However, there is much controversy on the definition.
Generally, economists consider household as an essential unit of analysis and developing theories based
on modeling household behavior. Chayanov model is the earliest one that integrates production and

consumption activities in analyzing the peasant households. By combining utility maximization from
consumption theory with the production from production theory, Chayanov model provides a
foundation for integrated model of household behavior (Nguyen, 2003).
As a conceptual concept, household is reckoned as a portfolio of economic resources, economic
activities, and flows between them (Tran, 2000). Household resources are set of human, physical, and
financial resources available for use by household in a given period. Household activities include
consumption, production and investment activities that household member undertake in a given period.
Household flows are sets of inputs and expenditures coming from household resources to support
household activities.
Besides, there are some definitions relating to the household. First, the household characteristics are
defined as things like household composition or household typical features such as number of adults,
children, occupation, age, and marital status. Second, household endowments are circumscribed as
5
assets, which cover various factors of household and natural talent quality or ability such as land,
labour, capital, inherit…(Nguyen, 2003).
2.1.2 Consumption
Consumption is the use of resources, goods, or services to satisfy want and need. It is exactly not the
same thing as the household expenditure on the consumer goods and services. Households want to
maintain a stable flow of services consumption those are the sources of utility to the households from a
given kind of commodity (Sach and Larrain, 1993).
Consumer goods comprise durables and nondurables. The distinction between them is the time they
provide utility to user. Commodities considered to be non-durables if they give utility only in the course
of using them up - a meal, a newspaper, and a weekend vacation. By contrast, other commodities
providing satisfaction to the household over a long period as motorcycle, television sets are durables.
According to Sach and Larrain (1993), consumption is properly measured as the sum of expenditures on
non-durables and the flow of services rendered by existing stock of consumer durables. That is, most of
current expenditures on consumer durables are actually investment spending rather than consumer
spending.
To some extend, definition of consumption is somewhat similar to expenditure. However, consumption
is still primarily analyzed in the context of utility, demand and other importance to market exchanges.

2.2 CONSUMPTION THEORIES
2.2.1 Keynes’ Consumption Function
Consumption is one of the key concepts in economics. As an initiative, in the General Theory published
in 1936, John Keynes made the consumption function central to his theory of economic fluctuations and
it has played a crucial role in macroeconomic analysis ever since.
Keynes started his theory with three conjectures about consumption function, which rest with his causal
observation. Those conjectures are:
6
(i) marginal propensity to consume (MPC) - the amount consumed out of an additional
dollar of income - is between zero and one,
(ii) average propensity to consume (APC) – defined as the ratio of consumption to
income – falls as income rises, and
(iii) income is the primary determinants of consumption and interest rate does not have
important role (Mankiw, 1997).
On this basis, a short run consumption model is often written as following:
C = C
0
+ MPC.Y C
0
> 0, 0<c<1 (1.1)
Where C : Household consumption
C
0
: Autonomous consumption, the constant consumption which is not based on income
MPC : Marginal propensity to consume
Y: Current income
Figure 1.1 Keynes’ consumption function
Source: Branson, 1989
This function reflects the tendency that as income increase people tend to spend a decreasing
percentage of income (Figure 1.1). The slope of linear consumption function is MPC and the slope from

the origin is the APC at that point. Apparently from the graph, the MPC is less than APC. Keynes
reasoned that as income falls relative to recent levels, people will protect consumption standards by not
cutting consumption proportionally to the drop in income, and conversely as income rises, consumption
will not rise proportionally (Branson, 1989).
7
C = C
0
+ MPC.Y
C
Y
C
0
Based on this standard function, another alternative consumption function with additional calculus’s
(adapted from Bui, 2002) could be:
Ln (C) = c
0
+ c
1
Ln (Y) (1.2)
The later one exposes clearer relationship between consumption and income. This result from the most
distinguished features of log-log consumption model is that the slope coefficient c
1
represents the
elasticity of consumption (C) with respect to income (Y). It can be interpreted as the percentage change
in consumption for a given percentage change in income, ceteris paribus. If c
1
equal to one, any
percentage change in income is fully absorbed by consumption regardless of long run or short run
change, permanent income or transitory income change.
Immediately after John Keynes introduced his consumption function, economists tried to test his

conjectures. The earliest studies indicated that the Keynes’ consumption function is a good
approximation of how household behave (Mankiw, 1997). However, incongruity arose when
economists examine long time-series household data. Typically, Kuznets discovered that APC is fairly
stable from decade to decade, despite large increase in income.
Although the consumption function that Keynes proposed has some limitations, it is considered to be a
milestone in the development of knowledge in this area. The function is still an excellent illustration of
how household behave in the short run. Yet, due to its simplicity, it is not commonly used in
consumption analysis.
2.2.2 Fisher’s Intertemporal Choice Model
Differently from current income based consumption model of Keynes, Irving Fisher developed the
model in which intertemporal choices of forward-looking household are taken into account. This model
illuminates the budget constraint that households face, the time preferences they have, and how these
factors influence to their consumption. This paper focuses on the intertemporal budget constraint, which
is the most relevant concept to scope of the study.
8
For simplicity, Fisher explored decision making of a household who lives in two periods with his
income constraint. He earns Y
1
in the first period and Y
2
in the second one. His consumption is C
1
and
C
2
respectively in the two periods.
In the first period, without any initial endowment, saving (S) equals income minus consumption.
S = Y
1
– C

1
(1.3)
In the second period, since no bequest left, consumption equals second period income (Y
2
) plus
accumulated saving included interest earning.
C
2
= (1 + r)S + Y
2
(1.4)
where r is interest rate. Substitute the equation (1.3) into the equation (1.4) we get:
C
2
= (1 + r)(Y
1
– C
1
) + Y
2
(1.5)
Divide both side of the equation (1.5) by (1 + r) and rearrange, we have
C
1
+ C
2
= Y
1
+ Y
2

(1+r) (1+r)
This equation can be understood as the present value of consumption and income. It is the standard way
of expressing the household’s intertemporal budget constraint. The implicitly in Fisher’s model is that a
household can consume more or less than its income in a specific period but over its lifetime, it cannot
consume more that its resources.
The budget constraint is interpreted as the combination of first-period and second-period consumption
that the household can choose. Figure 1.2 presents household’s budget constrained by a budget line.
Any point on this budget line represents possible intertemporal choice of the household. At point A, the
household consumes exactly what it earns in each period. If it chooses points between A and B, the
household consumes less than its income in the first period and save the rest for the second period. In
this case, the household shifts its present consumption to future consumption and vice versa if the
household chooses a point between A and C.
9
B
(1 + r)Y
1
+ Y
2
C
2
Figure 1.2 The household’s budget constraint
Source: Mankiw, 1997
The simple two-period budget constraint can be expanded to many periods case with or without initial
endowment and left bequest. That is:
t t t
2 2
1
t-1 t-1 t-1
1
C Y B

C Y
C + +...+ = (1+ r)E + Y + + ... + -
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r)
(1.7)
in which (1+r)E is the present value of initial endowment including interest payment; t is number of
periods (t = 1,2,…,n); B
t
is the amount of bequest left at the end of period t (adapted from Bui, 2002).
In conclusion, Irving Fisher developed intertemporal choice model showing how rational, forward-
looking household make its choices. The central idea is that household consumption does not simply
base on its current income but on the present value of current and future income. Relying on this
fundamental model, Franco Modigliani built up his life-cycle hypothesis (LCH) whereas Milton
Friedman introduced permanent income hypothesis (PIH) of consumption. These expanded models are
discussed in the next sections.
2.2.3 Modigliani’s Life-Cycle Hypothesis
To explain the three conjectures in Keynes’s consumption function discussed earlier, Franco Modigliani
postulated a life-cycle hypothesis of consumption. He emphasized that income varies systematically
over people’s lifetime and that saving allows consumer to move income from those time in life when
income is high to those time in life when it is low (Branson, 1989). As his argument, a typical
individual has an income stream that is relatively low at the beginning and end of his life. This income
10
C
1
C
A
Y
1
Y
2
Y

1
+ Y
2
/ (1 + r)
stream is shown as Y curve in Figure 1.3 where Y, C, S, and T are expected income, consumption,
saving and expected lifetime respectively.
Figure 1.3 The life-cycle hypothesis of consumption
Source: Branson, 1989
This model suggests that in the early years of people’s life, he is a net borrower, the first shaded area in
Figure 1.3. In the middle years, he saves to cover his debt and reserve income for smoothing
consumption in retirement period. He dissaves in the later years in his lifetime, the second shaded area.
Modigliani relied on two main assumptions. Those are:
(i) opportunity: smooth individual income until the retirement and after that his income
turns to zero, and
(ii) preference: consumption remains constant over individual lifetime and no bequest
left to next generation.
He differentiated his LCH on consumption by individual’s lifetime resources composition. He stated
that consumption is not solely based on expected income but also on wealth. Consider a consumer who
expects to live another T years has wealth of W, and expects to earn annual income Y until he retires R
years from now. Thus, consumer’s lifetime resources include both initial wealth W and lifetime earning
of R*Y. Assuming that consumer wishes to smooth his consumption, he will divide his lifetime
resources of W + R*Y evenly among T remaining years and in each year he consumes:
11
T
Y
C
Y,C
S
C =
W + R*Y

T
The function can be rearranged as:
C = 1 W + R
T T
This equation shows that an extra dollar increase in annual income raises consumption by (R/T) dollar
per year, and an extra dollar increase in wealth raise consumption by (1/T) dollar. In other words, (R/T)
is the MPC out of income and (1/T) is the MPC out of wealth. This consumption function can be
depicted in Figure 1.4 below.
Figure 1.4 The Life-cycle consumption function
The consumption function predicted by Modigliani is similar to the conventional consumption function
introduced by Keynes. Nonetheless, the intercept term (1/T)W is not a fixed value. It, instead, depends
on initial wealth. If the wealth increases, the consumption curve is shifted upward as presented in
Figure 1.4.
Modigliani also solved Keynes puzzle. Derive from equation (1.9), APC can be calculated by dividing
both side this equation by Y and we get:
C = 1 . W + R
Y T Y T
The economist argued that because wealth does not vary proportionally with income in the short run,
high income induces low APC. However over a long lifetime, wealth and income grow together,
resulting in a constant ratio W/Y and thus a constant APC (Mankiw, 1997).
12
C
2
= f(W
2
, Y)
C
Y
C
1

= f(W
1
, Y)
(1/T)W
2
(1/T)W
1
In brief, Franco Modigliani successfully developed intertemporal choices in his LCH on consumption,
which emphasized that income changes systematically over person’s life and that saving allows peoples
to smooth their consumption.
2.2.4 Friedman’s Permanent-Income Hypothesis
Another consumption theory expanded from intertemporal approach is permanent income hypothesis,
which is proposed by Milton Friedman in 1957. Unlike the LCH, which emphasized that income
follows a regular pattern over a person’s lifetime, the PIH highlighted that people experience random
and temporary changes in their income from year to year (Friedman, 1957). He suggested that income
should be viewed as a sum of permanent income (Y
P
) and transitory income (Y
T
).
Y = Y
P
+ Y
T
(1.11)
In which permanent income is defined as the average income that the household should expect over a
long time horizon while transitory income is the random deviation from that average.
Similarly, total consumption in any period is permanent consumption (C
P
) and random transitory

consumption (C
T
), which represents positive, negative, or zero deviation from the usual permanent
consumption level.
C = C
P
+ C
T
(1.12)
As Branson realized, PIH rests with three main assumptions.
(i) There is no correlation between permanent and transitory income.
(ii) There is no relationship between permanent and transitory consumption.
(iii) There is no relation ship between transitory consumption and transitory income.
Therefore, transitory consumption is not correlated with ether permanent consumption or transitory
income. It means that changes in permanent or transitory income does not affect to transitory
consumption. The transitory component has an expected value of zero (E[Y
T
] = 0) reflecting the notion
13
that over time transitory gains are offset by future transitory losses and vice-versa. Thus in the long run
observed levels of income 'Y' are equal to permanent income 'Y
P
'.
Consequently, Friedman concluded that consumption depends primary on permanent income because
household uses saving and borrowing to smooth consumption in response to transitory changes in
income. That is
C = α * Y
P
(1.13)
in which, α is a constant that measures the fraction of consumption out of permanent income.

Applying intertemporal approach in the PIH, Friedman formulated consumption function with budget
constraint in two periods as following:
C
1
+ C
2
= Y
P
+ Y
P
(1+r) (1+r)
It is clear that the PIH must satisfy the equation:
Y
P
+ Y
P
= Y
1
+ Y
2
(1+r) (1+r)
Solve this equation to find Y
P
:

P
2
1
Y(1+ r)
Y = [Y + ]

(2 + r) (1+ r)
(1.16)
A graphical representation of permanent income consumption is provided in Figure 1.5. Because Y
P
is
the average expected income over the two periods, the intersection of 45
0
line and the budget constraint
line is expected Y
P
. Point A is an extreme case when consumption is exactly equal to permanent income
in each period. In this special case of utility maximization, people tries to maintain fairly stable
consumption path so that he consumes the same every period. Saving and borrowing is used in response
to temporary changes in transitory income.
14
Figure 1.5 Household consumption and permanent income
Source: Sach and Larrain, 1993
In short, PIH on consumption postulated by Milton Friedman is an application of intertemporal
approach. It suggested that income should be viewed as a combination of permanent income and
transitory income. Accordingly, consumption should depend primarily on permanent income, and
saving is considered to be responsive factor to temporary income changes.
2.2.5 Hall’s Random-Walk Hypothesis
Rested with Irving Fisher’s intertemporal choice model, Franco Modigliani concentrated on the
structural relationship of expected income, wealth, and current consumption whereas Milton Friedman
developed his PIH showing that current consumption essentially relies on permanent income.
Developing this analogy, more recently Robert Hall has reformulated consumption theory by adding the
assumption of rational expectation to the intertemporal choice approach.
The rational expectation assumption states that people use all available information to make optimal
forecasts about he future income (Branson, 1989). Moving directly to reduced-form forecasting
equation, let us discuss Hall’s insight somewhat more carefully in terms of the intertemporal

consumption model.
P T
t+1 t
C =α *C + C
(1.17)
where t is the current point of time and t+1 is the next period.
15
Period 1
E
A
Y
1
Y
2
C
2
= Y
P
45
0
C
1
= Y
P
Utility curve
Period 2
The equation gives the expected value of the next period consumption C
t+1
, conditional on this period
consumption, C

t
, which is already known. When people receive news or information, his anticipation
must be revised and expected consumption is changed consequently. Hence, the expected value for
consumption is a total of permanent consumption and transitory consumption, which is the random
term.
If the present value of actual consumption C
t
incorporates all the relevant information in an unbiased
estimation of permanent income, then the expectations are rational, and the transitory component in the
equation (1.17) will indeed be random over time (Branson, 1989). Thus, the above equation can be seen
as a forecasting equation of anticipated consumption.
Adding rational expectation assumption to the basic Fisher’s intertemporal model, Robert Hall gives us
a reduced-form forecasting equation for consumption. It is apparently consistent with the basic
relationship of the whole consumption theory: current consumption depends on the present value of the
entire future income stream. This is the general starting point we have discussed.
2.3 EMPIRICAL STUDY REVIEW
Taking these theories of consumption as benchmark, various types of consumption function have been
examined by economists. Typical researcher who relied on life-cycle hypothesis of consumption is
Deaton (1997, 2002). He explored age profiles of consumption and saving in the C«te d’Ivoire,
Thailand and Taiwan. He stated that consumption profile is very close to the income profiles.
Implicitly, peoples smooth their consumption over the lifetime. More interestingly, he concluded “…
while it is possible that the age profiles of consumption are simply those that people like, and just
happen to match the shape of income profiles, it stretches belief that the coincidence should happen for
every educational and occupational groups as well as for a wide range of countries…”
Another direct test of permanent income hypothesis presented by De Juan, Seater and Wirjanto (2003)
uses time-series data of 48 contiguous US states. The research sets out to implement a direct test of the
implication of the PIH that the size of consumption revision due to an income innovation is equal to the
size of permanent income revision due to the same income innovation. For each state, the authors
jointly estimated the univariate income generating process and the equation describing the relation
16