Testing the Response of Consumption to Income Changes with (Noisy) Panel Data

This paper tests the rational expectations lifecycle model of consumption against (i) a simple Keynesian model and (ii) the rational expectations lifecycle model with imperfect capital markets. The tests are based upon the relative responsiveness of consumption to income changes which can be predicted from past information and income changes which cannot be predicted. Problems caused by measurement error in the income changes are circumvented by using the innovations from a vector autoregression of the measures of the determinants of income to form a noisy instrument for the unanticipated change in income, and using the lagged values of the measures of the income determinants to form an instrument for the anticipated income change. We show that the Keynesian model implies that the regression coefficients relating the change in consumption to the instruments for the anticipated and unanticipated components of the income change should be equal. The lifecycle model (with perfect capital markets) implies that only the instrument for the unanticipated component should affect consumption. The empirical results support the lifecycle model. In addition, we incorporate capital market imperfections into our empirical formulation of the lifecycle model by assuming that the marginal interest rate at a point in time is a differentiable, concave function of net assets. This leads to a test for capital market imperfections based upon whether consumption responds differently to positive and negative predictable changes in income. Our results are inconclusive.