ANTICIPATED AND UNANTICIPATED INCOME WITHIN THE CONSUMPTION FUNCTION: A RATIONAL EXPECTATIONS APPROACH

The rational expectations‐permanent income hypothesis (REPIH) is nothing new. The initial REPIH of Hall (1978) suggested that no other variable observed in earlier periods, given the inclusion of consumption lagged one period, should have any explanatory power for current consumption (Hall, p.972). The Hall version does not eliminate inclusion of current income in the explanation of consumption. Later work by Flavin (1981) finds that current income contains information about future income by providing signals to changes in permanent income. The means to reveal the innovation of current income signaling changes in permanent income has been to decompose current income into its anticipated and unanticipated components. Flavin suggests that unanticipated changes in current income may affect consumption by signaling changes in current income while anticipated changes in current income are included in the formation of permanent income thus having no affect on consumption.