Income uncertainty and consumption growth in the UK

There is much interest in the importance of 'precautionary saving' - the degree to which uncertainty affects household consumption behaviour. In this paper we use household level data on income and expenditure to analyse the importance of precautionary saving in the UK. Using the repeated cross-sections of the Family Expenditure Survey from 1968 to 1992 we decompose the shocks to a dynamic income process into common and individual-specific components. From these we compute conditional variances of the innovations which are used as risk terms in a consumption growth equation. It is not the variance of income but the conditional variance of innovations in the income process that determine the degree of precautionary saving. We estimate this process at both the micro and macro level and construct the variances of the innovations explicitly. In the absence of panel data on individual households we develop a grouping estimator that allows us to estimate this income process with conditional heteroskedasticity from repeated cross-section data. Construction of the relevent conditional variances and substitution into a consumption growth equation yields the expected positive effects - precautionary saving increases consumption growth by depressing consumption - consumers delay spending in the face of uncertainty as the life-cycle model predicts.