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The Excess Smoothness of Consumption: Identification and Interpretation

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  • Marjorie A. Flavin
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    Abstract

    The paper investigates the implications of the omitted information problem -- that is, the econometric problem which arises because an econometrician cannot explicitly include the complete set of variables potentially used by agents -- in the context of the "excess smoothness" phenomenon posed by Deaton 11987]. The paper shows that an econometrician who fails to take into account the effects of omitted information will incorrectly conclude that an empirical finding of excess smoothness of consumption implies that the income process is nonstationary. By contrast, with a more thorough understanding of the omitted information problem, the finding of excess smoothness of consumption is easily explained with two assumptions: a) the consumption data is generated by the excess sensitivity alternative hypothesis, in which consumption is a weighted average of current income and permanent income, and b) agents are forecasting on the basis of a larger information set than the econometrician. Further, excess smoothness is revealed to be consistent with a wide range of stationary income processes as well as nonstationary income processes. Thus the common presumption that the excess smoothness phenomenon is linked in an essential way to the stationarity or nonstationarity of the income process evaporates when omitted information is taken into consideration.

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    File URL: http://www.nber.org/papers/w2807.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2807.

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    Date of creation: Dec 1988
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    Publication status: published as Review of Economic Studies, Vol. 60, no. 204 (1993): 651-666.
    Handle: RePEc:nbr:nberwo:2807

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    1. Lars Peter Hansen & Thomas J. Sargent, 1981. "Exact linear rational expectations models: specification and estimation," Staff Report 71, Federal Reserve Bank of Minneapolis.
    2. Lawrence J. Christiano & Martin Eichenbaum & David Marshall, 1987. "The Permanent Income Hypothesis Revisited," NBER Working Papers 2209, National Bureau of Economic Research, Inc.
    3. John Y. Campbell & N. Gregory Mankiw, 1986. "Are Output Fluctuations Transitory?," NBER Working Papers 1916, National Bureau of Economic Research, Inc.
    4. Hayashi, Fumio, 1982. "The Permanent Income Hypothesis: Estimation and Testing by Instrumental Variables," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 895-916, October.
    5. Lawrence J. Christiano, 1987. "Is consumption insufficiently sensitive to innovations in income?," Staff Report 106, Federal Reserve Bank of Minneapolis.
    6. 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.
    7. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
    8. 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.
    9. Campbell, John Y & Mankiw, N Gregory, 1990. "Permanent Income, Current Income, and Consumption," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(3), pages 265-79, July.
    10. Kenneth D. West, 1987. "The Insensitivity of Consumption to News About Income," NBER Working Papers 2252, National Bureau of Economic Research, Inc.
    11. Nelson, Charles R. & Plosser, Charles I., 1982. "Trends and random walks in macroeconmic time series : Some evidence and implications," Journal of Monetary Economics, Elsevier, vol. 10(2), pages 139-162.
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    Cited by:
    1. Stephen R. Blough, 1994. "Near common factors and confidence regions for present value models," Working Papers 94-3, Federal Reserve Bank of Boston.
    2. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Working Papers 2924, National Bureau of Economic Research, Inc.
    3. Li-gang Liu & Laurent Pauwels & Andrew Tsang, 2007. "Hong Kong's Consumption Function Revisited," Working Papers 0716, Hong Kong Monetary Authority.

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