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Risky Habits and the Marginal Propensity to Consume Output of Permanent Income, or, How Much Would a Permanent Tax Cut Boost Japanese Consumption?

  • D. Carroll Christopher

Papers in a variety of disparate literatures have recently suggested that habit formation in consumption may explain several empirical puzzles, ranging from the level and cyclical variability of the equity premium (Abel, 1990, 1999: Constantinides, 1990; Jerman, 1998; Campbell and Cochrane, 1999) to the 'excess smoothness' of aggregate consumption (Fuhrer, 2000) to the apparent fact that increases in economic growth cause subsequent increase in aggregate saving rates (Carroll and Weil, 1994: Bosworth, 1993; Attanasio, Picci, and Scorceu, 2000; Rodrik, 1999; Layza, Schmidt-Hebbel, and Serven, 2000) This paper examines an implication of these models that has mostly been overlooked: Habits strong enough to solve these puzzles imply an immediate marginal propensity to consume out of permanent shocks of much lees than one. When the model is calibrated to roughly match the rise in the Japanese saving rate over the postwar periode, it implies that the immediate MPC out of Permanent tax cuts may be as low as 30 percent, suggesting that calls for a permanent income tax cut as a quick means of stimulating aggregate demand in Japan may be misguided. [D11, D81, D91, E10, E17, E21, H31]

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Article provided by Taylor & Francis Journals in its journal International Economic Journal.

Volume (Year): 14 (2000)
Issue (Month): 4 ()
Pages: 1-40

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Handle: RePEc:taf:intecj:v:14:y:2000:i:4:p:1-40
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  1. Loayza, N. & Schmidt, K. & Serven, L., 1999. "What Drives Private Saving Across the World?," Papers 47, Cambridge - Risk, Information & Quantity Signals.
  2. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  3. Ohtake, F. & Horioka, C.Y., 1995. "Saving Motives in Japan," ISER Discussion Paper 0392, Institute of Social and Economic Research, Osaka University.
  4. Horioka, C.Y. & Watanabe, W., 1996. "Why Do People Save? A Micro-Analysis of Motives for Household Saving in Japan," ISER Discussion Paper 0412, Institute of Social and Economic Research, Osaka University.
  5. Christopher D. Carroll & Miles S. Kimball, 1995. "On the concavity of the consumption function," Finance and Economics Discussion Series 95-10, Board of Governors of the Federal Reserve System (U.S.).
  6. Miles S. Kimball, 1990. "Precautionary Saving and the Marginal Propensity to Consume," NBER Working Papers 3403, National Bureau of Economic Research, Inc.
  7. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  8. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  9. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
  10. Chris Carroll & Lawrence H. Summers, 1989. "Consumption Growth Parallels Income Growth: Some New Evidence," NBER Working Papers 3090, National Bureau of Economic Research, Inc.
  11. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, vol. 59(5), pages 1221-48, September.
  12. Christopher D. Carroll & David N. Weil, 1993. "Saving and growth: a reinterpretation," Working Paper Series / Economic Activity Section 140, Board of Governors of the Federal Reserve System (U.S.).
  13. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  14. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May.
  15. Angus Deaton & Christina Paxson, 1997. "The effects of economic and population growth on national saving and inequality," Demography, Springer, vol. 34(1), pages 97-114, February.
  16. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  17. Christopher D. Carroll, 1992. "The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 23(2), pages 61-156.
  18. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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