Question

Under the Rational Expectations/Permanent Income Hypothesis, current sentiment should not affect future consumption. Why?

Answer 1

The Permanent Theory Hypothesis is a theory that focuses on consumer spending and highlights the point that consumers spend their money at a level consistent with their expected long-term average income. The hypothesis implies that changes in consumption behaviour are not predictable because they are based on individual expectations.

Let us consider an example: A worker if a worker is aware that he is like to receive an increment in his salary/ wage, it is possible that the worker's spending may change in anticipation of the additional earnings. However, it is also possible that he may not choose to increase his spending but rather may save the additional amount thereby boosting his savings.

The above example clearly portrays that the behaviour or sentiment of a consumer is unpredictable and there under the Rational Expectations/ Permanent Income Hypothesis, the current sentiment ideally should not affect future consumption.