Pakistan Journal of Social Sciences (PJSS) Vol. 31, No. 2 (December 2011), pp. 299-307 Permanent Income Hypothesis, Myopia and Liquidity Constraints: A Case Study of Pakistan Khalid Khan Lecturer of Economics Lasbela University of Agriculture, Email: khalidkk82@yahoo.com Mohammed Nishat Professor of Finance and Economics, Institute of Business Administration (IBA), Karachi Email: mnishat@iba.edu.pk Abstract In this paper, it is attempted to test the permanent income hypothesis (PIH) for Pakistan. If the PIH is not valid for Pakistan the study also attempts to find out the reasons for rejection of PIH. Hall’s random walk model (1978) and Campbell and Mankiw model (1990) are used to test for the validity of PIH. The results of this study indicate the strong validity of absolute income hypothesis (AIH) rather than PIH. Therefore, to find out the reasons for the rejection of the PIH in Pakistan we used Shea (1995) model. The results of the Shea (1995) model rejected the symmetric relationship between consumption and expected income and provide a little evidence of existence of liquidity constraints. Keywords: Permanent Income Hypothesis; Absolute Income Hypothesis; Symmetric Relationship; Liquidity Constraints I. Introduction The empirical puzzle of Keynes psychological law of consumption provides the opportunity to extend the consumption literature. To answer Kuznets’s (1946) empirical puzzle, different economists introduced their consumption theories such as relative income hypothesis (RIH) by Duesenberry (1948), life cycle hypothesis (LCH) by Modigliani and Brumbergh (1954) and permanent income hypothesis (PIH) by Friedman (1957). According to Duesenberry (1948) consumption of the individual depends upon its relative income rather than its absolute income. But according to PIH consumption of individual which is explained by its permanent rather than its relative income and current income, while the LCH forwards the same argument in a different prospective. According to LCH the consumption of individual is explained by its expected life time income, so the PIH and LCH share the same optimizations model and conclusion. But in empirical work the PIH is more popular than LCH, while the RIH is not tested widely because of unavailability of data for key variables. To test the PIH, Friedman (1957) estimated the permanent income by using the distributive lags of current income. Lucas (1976) postulated that the lags of current income do not explain the current consumption. In the response to Lucas (1976) critique, Hall (1978) showed that without current consumption other variables have no