Measurement Errors and the Permanent Income Hypothesis: Evidence from Rural India.

by Surjit S. Bhalla

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Attempts to test, and distinguish between, the current income and Milton Friedman's permanent income hypothesis of consumption behavior. Resolution of the importance of the current income/permanent income distinction has important implications for understanding habit and lags in consumption behavior and the efficacy of short-run macroeconomic policies. The validity of the hypothesis that permanent consumption is proportional to permanent income (proportionality hypothesis) has an important bearing on the controversy regarding the trade-off between growth and equity in developing countries. This report extends the permanent income hypothesis to allow for the presence of pure measurement error in the major variables. The empirical estimation of the variance of these errors is possible because independent estimates of consumption, savings, and income are available. Incorporation of error variances in the analysis insures that tests of Friedman's theory are theoretically correct and most rigorous to date. Further, accounting for these errors permits estimation of unbiased parameters in the traditional consumption income relationship. 47 pp. Bibliog.

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