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The Excess Smoothness of Consumption: Identification and Interpretation

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  • Marjorie A. Flavin

Abstract

The paper investigates the implications of the omitted information problem -- that is, the econometric problem which arises because an econometrician cannot explicitly include the complete set of variables potentially used by agents -- in the context of the "excess smoothness" phenomenon posed by Deaton 11987]. The paper shows that an econometrician who fails to take into account the effects of omitted information will incorrectly conclude that an empirical finding of excess smoothness of consumption implies that the income process is nonstationary. By contrast, with a more thorough understanding of the omitted information problem, the finding of excess smoothness of consumption is easily explained with two assumptions: a) the consumption data is generated by the excess sensitivity alternative hypothesis, in which consumption is a weighted average of current income and permanent income, and b) agents are forecasting on the basis of a larger information set than the econometrician. Further, excess smoothness is revealed to be consistent with a wide range of stationary income processes as well as nonstationary income processes. Thus the common presumption that the excess smoothness phenomenon is linked in an essential way to the stationarity or nonstationarity of the income process evaporates when omitted information is taken into consideration.

Suggested Citation

  • Marjorie A. Flavin, 1988. "The Excess Smoothness of Consumption: Identification and Interpretation," NBER Working Papers 2807, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:2807
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    References listed on IDEAS

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    1. 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 971-987, December.
    2. Christiano, Lawrence J & Eichenbaum, Martin & Marshall, David, 1991. "The Permanent Income Hypothesis Revisited," Econometrica, Econometric Society, vol. 59(2), pages 397-423, March.
    3. Lars Peter Hansen & Thomas J. Sargent, 1981. "Exact linear rational expectations models: specification and estimation," Staff Report 71, Federal Reserve Bank of Minneapolis.
    4. John Y. Campbell & N. Gregory Mankiw, 1987. "Are Output Fluctuations Transitory?," The Quarterly Journal of Economics, Oxford University Press, vol. 102(4), pages 857-880.
    5. Campbell, John Y & Mankiw, N Gregory, 1990. "Permanent Income, Current Income, and Consumption," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(3), pages 265-279, July.
    6. Christiano, Lawrence J, 1987. "Is Consumption Insufficiently Sensitive to Innovations in Income?," American Economic Review, American Economic Association, vol. 77(2), pages 337-341, May.
    7. West, Kenneth D., 1988. "The insensitivity of consumption to news about income," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 17-33, January.
    8. Campbell, John Y, 1987. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," Econometrica, Econometric Society, vol. 55(6), pages 1249-1273, November.
    9. 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.
    10. Nelson, Charles R. & Plosser, Charles I., 1982. "Trends and random walks in macroeconmic time series : Some evidence and implications," Journal of Monetary Economics, Elsevier, vol. 10(2), pages 139-162.
    11. 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.
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    Cited by:

    1. Li-gang Liu & Laurent Pauwels & Andrew Tsang, 2007. "Hong Kong's Consumption Function Revisited," Working Papers 0716, Hong Kong Monetary Authority.
    2. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters,in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246 National Bureau of Economic Research, Inc.
    3. Stephen R. Blough, 1994. "Near common factors and confidence regions for present value models," Working Papers 94-3, Federal Reserve Bank of Boston.

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