Explain the content of the random walk hypothesis for privat

Explain the content of the random walk hypothesis for private consumption. Explain the difference between the dynamics of private consumption under static and under rational expectations.

Solution

The random walk model of consumption was introduced by economist Robert Hall. He incorporated the idea of rational expectations into his consumption models and sets up the model so that consumers will maximize their utility. Private consumption is the principal component of GDP from the expenditure approach. His theory states that imposing rational expectations produces the result that consumption is a random walk, the best prediction of future consumption is the present level of consumption. If consumers obey the permanent-income hypothesis and have rational expectations, then only unexpected policy changes influence consumption.

Static expectations states that people expect the value of an economic variable next period to be equal to the current value of this variable. Economists used the assumptions of static expectations until the concept of rational expectations was developed. The rational expectations theory is an economic concept where people make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in an economy are equivalent to what people think the future state of the economy will become. The main criticism of the concept of static expectations is that it assumes that people ignore the information about possible shifts in policy variables whereas rational expectations assumption incorporates all possible information available at the time the expectations are formulated, not just the past values of the variable being forecasted, as is the case with static expectations.