Estimating Excess Sensitivity and Habit Persistence in Consumption Using Greenbook Forecasts

In this paper, we revisit the issue of excess sensitivity of consumption to income and address the weak instrument problem that is well documented in this literature. Using quarterly data for the US economy, we first highlight the weak instrument problem by showing that the use of conventional instruments tends to overestimate the share of rule‐of‐thumb consumers. To address this weak instrument problem, we propose a new instrument for endogenous disposable income growth in the consumption function, namely, the Greenbook forecast of real disposable income growth. We show that this instrument encompasses the information contained in the conventional set of instruments, and is a superior predictor of income growth. We find that using our proposed instrument ameliorates the weak instrument problem and provides a much smaller estimate for the rule‐of‐thumb consumers. We also extend our empirical framework to allow for habit persistence and provide an estimate for this important parameter of the consumption function. Finally, we use a time‐varying specification of consumption function that allows for endogenous regressors, and document a decline in the share of rule‐of‐thumb consumers and a rise in the habit‐persistence parameter in the US over our sample period.