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The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives

  • Cochrane, John H

Suppose a consumer sets consumption equal to income each period, rather than following the optimal permanent income decision rule. How much utility does he lose? This paper finds that the answer is typically less than 10 cents-$1 per quarter in environments specified by popular tests on aggregate data. It includes calculations of the costs of excess sensitivity and excess smoothness to income and interest rate changes and the costs of ignoring information. It concludes that the theory does not make predictions for aggregate tests that are robust to small costs, such as information or transactions. Copyright 1989 by American Economic Association.

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 79 (1989)
Issue (Month): 3 (June)
Pages: 319-37

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Handle: RePEc:aea:aecrev:v:79:y:1989:i:3:p:319-37
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  1. Cochrane, John H. & Sbordone, Argia M., 1988. "Multivariate estimates of the permanent components of GNP and stock prices," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 255-296.
  2. George A. Akerlof, 1979. "Irving Fisher on his Head: The Consequences of Constant Threshold-Target Monitoring of Money Holdings," The Quarterly Journal of Economics, Oxford University Press, vol. 93(2), pages 169-187.
  3. Gregory Mankiw, N. & Shapiro, Matthew D., 1985. "Trends, random walks, and tests of the permanent income hypothesis," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 165-174, September.
  4. Jones, Stephen R G & Stock, James H, 1987. "Demand Disturbances and Aggregate Fluctuations: The Implications of Near Rationality," Economic Journal, Royal Economic Society, vol. 97(385), pages 49-64, March.
  5. 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.
  6. John Y. Campbell & Angus Deaton, 1987. "Is Consumption Too Smooth?," NBER Working Papers 2134, National Bureau of Economic Research, Inc.
  7. 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.
  8. Larry G. Epstein & Stanley E. Zin, 1987. "Substitution, Risk Aversion and the Temporal Behaviour of Consumption and Asset Returns I: A Theoretical Framework," Working Papers 699, Queen's University, Department of Economics.
  9. Larry G. Epstein & Stanley E. Zin, 1987. "Substitution, Risk Aversion and the Temporal Behaviour of Consumption and Asset Returns II: An Empirical Analysis," Working Papers 698, Queen's University, Department of Economics.
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