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Habits, Sentiment and Predictable Income in the Dynamics of Aggregate Consumption

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Author Info
Martin Sommer (International Monetary Fund)

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Abstract

This paper explores whether habit formation in the representative agent’s preferences can explain two failures of the standard permanent income model: the sensitivity to lagged consumer sentiment, and to predictable changes in income. I show that in a habit formation model, the sensitivity of consumption to predicted income can be largely reinterpreted as a sluggish response to news. Moreover, the sensitivity of consumption to sentiment reflects the serial correlation in consumption growth generated by habits. The estimated model predicts an immediate (first-quarter) MPC out of a permanent tax cut of only about 30%.

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Paper provided by EconWPA in its series Macroeconomics with number 0408004.

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Length: 28 pages
Date of creation: 09 Aug 2004
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Handle: RePEc:wpa:wuwpma:0408004

Note: Type of Document - pdf; pages: 28
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Web page: http://129.3.20.41

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Related research
Keywords: Consumer sentiment; excess sensitivity; habit formation; consumption; marginal propensity to consume; tax cuts;

Find related papers by JEL classification:
E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household

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References listed on IDEAS
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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, vol. 86(6), pages 971-87, December. [Downloadable!] (restricted)
  2. John Muellbauer, 1988. "Habits, Rationality and Myopia in the Life Cycle Consumption Function," Annales d'Economie et de Statistique, ADRES, issue 9, pages 04, Janvier-M. [Downloadable!]
    Other versions:
  3. Christopher D. Carroll & Jody Overland & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, vol. 90(3), pages 341-355, June. [Downloadable!] (restricted)
    Other versions:
  4. Carroll, Christopher D, 1997. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," The Quarterly Journal of Economics, MIT Press, vol. 112(1), pages 1-55, February.
    Other versions:
  5. Christopher D Carroll, 2000. "'Risky Habits' and the Marginal Propensity to Consume Out of Permanent Income or How Much Would a Permanent Tax Cut Boost Japanese Consumption?," Economics Working Paper Archive 429, The Johns Hopkins University,Department of Economics.
    Other versions:
  6. Abel, A.B., 1990. "Asset Prices Under Habit Formation And Catching Up With The Joneses," Weiss Center Working Papers 1-90, Wharton School - Weiss Center for International Financial Research.
    Other versions:
  7. Carroll, Christopher D & Fuhrer, Jeffrey C & Wilcox, David W, 1994. "Does Consumer Sentiment Forecast Household Spending? If So, Why?," American Economic Review, American Economic Association, vol. 84(5), pages 1397-1408, December. [Downloadable!] (restricted)
    Other versions:
  8. Marianne Baxter & Urban J. Jermann, 1999. "Household Production and the Excess Sensitivity of Consumption to Current Income," American Economic Review, American Economic Association, vol. 89(4), pages 902-920, September. [Downloadable!] (restricted)
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  9. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April. [Downloadable!] (restricted)
  10. Martin Sommer & Christopher Carroll, 2004. "Epidemiological expectations and consumption dynamics," Money Macro and Finance (MMF) Research Group Conference 2003 92, Money Macro and Finance Research Group. [Downloadable!]
  11. Matthew D. Shapiro & Joel Slemrod, 2001. "Consumer Response to Tax Rebates," NBER Working Papers 8672, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Pischke, J.S., 1993. "Individual Income, Incomplete Information, and Aggregate Consumption," Working papers 93-16, Massachusetts Institute of Technology (MIT), Department of Economics.
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  13. repec:fth:harver:1435 is not listed on IDEAS
  14. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, vol. 91(3), pages 631-647, June. [Downloadable!] (restricted)
  15. Deaton, A. & Grosh, M., 1998. "Consumption," Papers 191, Princeton, Woodrow Wilson School - Development Studies.
  16. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June. [Downloadable!] (restricted)
  17. Christiano, Lawrence J & Eichenbaum, Martin & Marshall, David, 1991. "The Permanent Income Hypothesis Revisited," Econometrica, Econometric Society, vol. 59(2), pages 397-423, March. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jiri Slacalek, 2006. "International Wealth Effects," Discussion Papers of DIW Berlin 596, DIW Berlin, German Institute for Economic Research. [Downloadable!]
    Other versions:
  2. Marco Malgarini & Patrizia Margani, 2005. "Psychology, consumer sentiment and household expenditures: a disaggregated analysis," ISAE Working Papers 58, ISAE - Institute for Studies and Economic Analyses - (Rome, ITALY). [Downloadable!]
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This page was last updated on 2009-11-30.

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