COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 725

"Trends, Random Walks, and Tests of the Permanent Income Hypothesis"

N. Gregory Mankiw and Matthew D. Shapiro

September 1984

Recent studies find that consumption is excessively sensitive to income. These studies assume that income is stationary around a deterministic trend. The data, however, do not reject the hypothesis that disposable income is a random walk with drift. If income is indeed a random walk, then the standard testing procedure is greatly biased toward finding excess sensitivity. Moreover, if income is borderline stationary, this procedure is also seriously biased.

JEL Classification: 131, 211, 921

Keywords: Non-stationary time series, detrending, permanent income hypothesis, small sample bias