Consumption smoothing: Hall’s theory of consumption
About this app
A forward-looking model household over 40 years: income rises, pensions fall, consumption stays flat because the household spreads everything it expects evenly. An announced pay rise changes nothing when it arrives; only a surprise shifts the plan, a permanent one strongly, a one-off one a little. With a share of hand-to-mouth households (Hall 1978, Hall and Mishkin 1982).
With explain mode: an AI tutor walks you through the app, points out what matters in the scene and answers your questions.
What it is about
Robert E. Hall, Nobel laureate in economic sciences 2026 together with Michael Woodford, showed in 1978: if households plan ahead, they spread everything they expect over their lifetime as evenly as possible across the years. Consumption then follows permanent income, not this year’s income. Expected changes are already part of the plan; only new information can change it. Because news is unpredictable by definition, changes in consumption cannot be predicted either. This implication could be tested in data and largely held. Hall and Mishkin found in household data in 1982 that about 80 per cent follow the theory and about 20 per cent live hand-to-mouth.
What the app shows
A model household over 40 years: income of 28 thousand euros in the first ten years, 40 from year 10, a pension of 32 from year 30. The household spreads its lifetime income of 1400 evenly and consumes 35 per year. Areas show saving and dissaving, a dashed line the plan from the current year. Below, bars show the changes from the previous year: at the expected rise at year 10 income jumps by 12 and consumption not at all. A surprising permanent rise of 5 from year 15 lifts consumption to 38.
Try it yourself
Let the years run and watch the bars at year 10 and year 15. Switch the change from surprise to announced: the household then plans for it from the start and consumption no longer jumps. Compare a one-off with a permanent rise of the same size. Finally raise the share of households without savings and see how total consumption now also reacts to expected income changes.
Frequently asked questions
- What does the permanent income hypothesis say?
- Households base their consumption on the income they expect over a long time, not on this year’s income. They even out fluctuations by saving and borrowing. The idea goes back to Milton Friedman and Franco Modigliani; Robert Hall turned it into a testable prediction in 1978.
- Why does consumption follow a random walk according to Hall?
- If today’s consumption already reflects all available information, it changes only when new information arrives. New information cannot be predicted, so neither can changes in consumption. Known data then do not help to forecast the next change.
- What does “hand-to-mouth” mean in macroeconomics?
- Households without savings and without access to credit cannot smooth their consumption and spend what they currently earn. Hall and Mishkin estimated their share at about 20 per cent in 1982. Today’s central bank models include such households next to forward-looking ones.
- Are the numbers in the app real data?
- No. They are model values in thousand euros per year, with a zero interest rate and a certain lifetime. They show the principle; real households face uncertainty, interest rates and credit limits.
Subject: Economics
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