Is consumption insufficiently sensitive to innovations in income?
Deaton (1986) has noted that if income is a first-order autoregressive process in first differences, then a simple version of Friedman’s permanent income hypothesis (SPIH) implies that measured U.S. consumption is insufficiently sensitive to innovations in income. This paper argues that this implication of the SPIH is a consequence of the fact that it ignores the role of the substitution effect in the consumption decision. Using a parametric version of the standard model of economic growth, the paper shows that very small movements in interest rates are sufficient to induce an empirically plausible amount of consumption smoothing. Since an overall evaluation of the model’s explanation for the observed smoothness of consumption requires examining its implications for other aspects of the data, the paper also explores some of these.
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- Kydland, Finn E & Prescott, Edward C, 1982.
"Time to Build and Aggregate Fluctuations,"
Econometric Society, vol. 50(6), pages 1345-1370, November.
- Finn E. Kydland & Edward C. Prescott, 1982. "Executable program for "Time to Build and Aggregate Fluctuations"," QM&RBC Codes 4, Quantitative Macroeconomics & Real Business Cycles.
- Finn E. Kydland & Edward C. Prescott, 1982. "Web interface for "Time to Build and Aggregate Fluctuations"," QM&RBC Codes 4a, Quantitative Macroeconomics & Real Business Cycles.
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