Financial Market Assignment Example | Topics and Well Written Essays - 2500 words

Financial Market - Assignment Example The random walk behavior of macroeconomic aggregates can be produced by a wide variety of complicated behavior at the microeconomic level. If income follows a random walk process, any innovation in income or a change in income due to an economic shock is an unexpected change in permanent income affecting consumption growth. The predictive ability of unexpected permanent or actual growth in income is consistent with permanent income hypothesis (PIH). Within the framework of time-series modeling, it was suggested that the standard test is biased towards finding excess sensitivity when disposable income follows a random walk process. If income follows a random walk, the permanent income equals current income. Assuming that permanent income hypothesis is true and consumption equals income since series contains a unit root, the procedures of standardized testing are not valid. If both consumption and income are de-trended, spurious cycles would be exhibited by both series. Since consumption tracks income perfectly over these transitory cycles, it can be concluded that consumption is excessively sensitive to contemporaneous income. The excess sensitivity of consumption does not provide evidence against the permanent income hypothesis unless the income is shown as not to have properties of random walk. The random walk process is followed by the real disposable income. Actual real disposable income approximates real permanent disposable income which determines household consumption. The origins of random walk process of real disposable income are on the supply side including factors of capital market restrictions, changes in trade, capital accumulation, technological adaptation and innovation, climatic and weather change etc. These supply-side shocks have a long-term impact on income and consumption.