Permanent Income and Consumption

A theory of consumer spending which states that people will spend money at a level consistent with their expected long term average income is briefly recapitulated. The level of expected long term income then becomes thought of as the level of "permanent" income that can be safely spent. The permanency can be seen as following an adaptive expectation process what enables to compute values of the variable which in fact is unobservable. A marginal propensity to consume is then easy to find by applying OLS to a simple model. Nevertheless, a question arises whether in reality the response of consumption to income is consistent with such a hypothesis. A validation of the permanent income hypothesis is performed using an instrumental variables approach.