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Looking for the News in the Noise - Additional Stochastic Implications of Optimal Consumption Choice

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  • Laurence J. Kotlikoff
  • Ariel Pakes

Abstract

In neoclassical models of consumption choice under earnings uncertainty changes in consumption programs from one period to the next are determined by new information received about future earnings over the period. This proposition suggests testing the neoclassical model by ascertaining whether new earnings information explains consumption choice through time. It also suggests that actual consumption choices imbed extractable information about the extent and time resolution of earnings uncertainty. This paper derives a fairly general theoretical relationship between properly defined innnovations in consumption (noise) and revisions in expectations of lifetime earnings (news). It also clarifies the relationship between testing for the theoretical determinants of consumption and standard Euler tests that focus on theoretical nondeterminants of consumption. The chief prediction of the paper's theoretical results, that noise exactly equals news, is tested using aggregate time series data on consumption and earnings. We find that new earnings information explains only a very small fraction of the variance of aggregate consumption innovations. On the other hand, the extent of suboptimal consumption choice appears to be of little economic significance.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1492.

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Date of creation: Nov 1984
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Publication status: published as "Looking for the News in the Noise. Additional Stochastic Implications of Optimal Consumption Choice." From Annales D'Economie et de Statistique, Vol. 9, pp. 29-46, (1988).
Handle: RePEc:nbr:nberwo:1492

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  1. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 86(6), pages 971-87, December.
  2. Sargent, Thomas J, 1978. "Rational Expectations, Econometric Exogeneity, and Consumption," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 86(4), pages 673-700, August.
  3. Eden, Benjamin & Pakes, Ariel, 1981. "On Measuring the Variance-Age Profile of Lifetime Earnings," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 48(3), pages 385-94, July.
  4. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 249-65, April.
  5. Mankiw, N Gregory & Rotemberg, Julio J & Summers, Lawrence H, 1985. "Intertemporal Substitution in Macroeconomics," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(1), pages 225-51, February.
  6. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 89(5), pages 974-1009, October.
  7. Mervyn A. King, 1983. "The Economics of Saving," NBER Working Papers 1247, National Bureau of Economic Research, Inc.
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Cited by:
  1. Kenneth D. West, 1987. "The Insensitivity of Consumption to News About Income," NBER Working Papers 2252, National Bureau of Economic Research, Inc.
  2. Fumio Hayashi, 1985. "Tests for Liquidity Constraints: A Critical Survey," NBER Working Papers 1720, National Bureau of Economic Research, Inc.
  3. Carl E. Walsh, 1985. "Borrowing Restrictions and Wealth Constraints: Implications for Aggregate Consumption," NBER Working Papers 1629, National Bureau of Economic Research, Inc.

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