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On the relationships between real consumption, income and wealth

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  • Michael Palumbo
  • Jeremy Rudd
  • Karl Whelan

Abstract

The existence of durable goods implies that the welfare flow from consumption cannot be directly associated with total consumption expenditures. As a result, tests of standard theories of consumption (such as the Permanent Income Hypothesis, or PIH) typically focus on nondurable goods and services. Specifically, these studies generally relate real consumption of nondurable goods and services to measures of real income and wealth, where the latter are deflated by a price index for total consumption expenditures. We demonstrate that this procedure is only valid under the assumption that real consumption of nondurables and services is a constant multiple of aggregate real consumption outlays--an assumption that represents a very poor description of U.S. data. We develop an alternative approach that is based on the observation that the ratio of these series has historically been stable in nominal terms, and use this approach to examine two basic predictions of the PIH. We obtain significantly different results relative to the traditional approach.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-38.

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Date of creation: 2002
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Handle: RePEc:fip:fedgfe:2002-38

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Keywords: Consumption (Economics);

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  1. Gali, Jordi, 1990. "Finite horizons, life-cycle savings, and time-series evidence on consumption," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 433-452, December.
  2. John Y. Campbell, 1986. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," NBER Working Papers 1805, National Bureau of Economic Research, Inc.
  3. Hansen, Lars Peter & Sargent, Thomas J., 1980. "Formulating and estimating dynamic linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 7-46, May.
  4. Campbell, John & Deaton, Angus, 1989. "Why Is Consumption So Smooth?," Scholarly Articles 3221494, Harvard University Department of Economics.
  5. Whelan, Karl, 2003. " A Two-Sector Approach to Modeling U.S. NIPA Data," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(4), pages 627-56, August.
  6. Alan S. Blinder & Angus Deaton, 1985. "The Time Series Consumption Function Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(2), pages 465-521.
  7. Davidson, James E H, et al, 1978. "Econometric Modelling of the Aggregate Time-Series Relationship between Consumers' Expenditure and Income in the United Kingdom," Economic Journal, Royal Economic Society, vol. 88(352), pages 661-92, December.
  8. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
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