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Excess Sensitivity of Consumption to Current Income: Liquidity Constraints or Myopia?

  • Marjorie A. Flavin
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    Almost all of the recent empirical tests of the rational expectations - permanent income hypothesis (RE-PIH) have rejected the hypothesis. The null hypothesis in this empirical literature typically consists of the joint hypothesis that 1) agents' expectations are formed rationally, 2) desired consumption is determined by permanent income, and 3) capital markets are"perfect" in the sense that agents can lend or borrow against expected future income at the same interest rate. This paper attempts to determine whether the excess sensitivity of consumption to current income can be attributed to a failure of the third component of the joint hypothesis -- the assumption of "perfect" capital markets -- as opposed to a failure of one or both of the first two assumptions. The paper examines, as a specific alternative to the PIH, a simple "Keynesian" consumption function in which the behavioral MPC out of transitory income is different from zero. Interpreting the unemployment rate as a proxy for the proportion of the population subject to liquidity constraints, the paper uses a generalized version of the econometric model in my earlier paper(1981) to conduct a specification test of the "Keynesian" consumption function. The finding that the estimate of the MPC out of transitory income is dramatically affected, in both magnitude and statistical significance, by the inclusion of the proxy for liquidity constraints suggests that liquidity constraints are an important part of the explanation of the observed excess sensitivity of consumption to current income.

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    File URL: http://www.nber.org/papers/w1341.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1341.

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    Date of creation: May 1984
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    Publication status: published as Flavin, Marjorie."Excess Sensitivity of Consumption to Current Income: Liquidity Constraints of Myopia?" Canadian Journal of Economics, Vol. 18, No. 1, pp. 117-136, February 1985.
    Handle: RePEc:nbr:nberwo:1341
    Note: EFG
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    1. Blinder, Alan S, 1981. "Temporary Income Taxes and Consumer Spending," Journal of Political Economy, University of Chicago Press, vol. 89(1), pages 26-53, February.
    2. Hausman, Jerry A, 1975. "An Instrumental Variable Approach to Full Information Estimators for Linear and Certain Nonlinear Econometric Models," Econometrica, Econometric Society, vol. 43(4), pages 727-38, July.
    3. George A. Akerlof & Brian G. M. Main, 1978. "Unemployment spells and unemployment experience," Special Studies Papers 123, Board of Governors of the Federal Reserve System (U.S.).
    4. Ben S. Bernanke, 1981. "Permanent Income, Liquidity, and Expenditure on Automobiles: Evidence from Panel Data," NBER Working Papers 0756, National Bureau of Economic Research, Inc.
    5. Mervyn A. King & Louis Dicks-Mireaux, 1981. "Asset Holdings and the Life Cycle," NBER Working Papers 0614, National Bureau of Economic Research, Inc.
    6. 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.
    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. King, M A & Dicks-Mireaux, L-D L, 1982. "Asset Holdings and the Life-Cycle," Economic Journal, Royal Economic Society, vol. 92(366), pages 247-67, June.
    9. Hayashi, Fumio, 1982. "The Permanent Income Hypothesis: Estimation and Testing by Instrumental Variables," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 895-916, October.
    10. Mervyn A. King, 1983. "The Economics of Saving," NBER Working Papers 1247, National Bureau of Economic Research, Inc.
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