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Regional heterogeneity in consumption due to current income shocks: New evidence from the Permanent Income Hypothesis


  • Timo Mitze



In the light of new theoretical and empirical work on the Permanent Income Hypothesis we tackle earlier findings for German data, which reject its validity given a large fraction of liquidity constrained consumers. Starting from a standard short run approach we do not find evidence for excess sensitivity and thus liquidity constrained households in the context of a dynamic panel data model for German states between 1970 and 2006. Our preferred specification relates changes in consumption to a 'surprise' term in permanent income as well as past values of consumption growth. We can interpret this specification as a solution to a consumer's optimization problem with habit persistence. Different from earlier findings changes of income growth measuring the excess sensitivity of consumption with respect to income changes and thus the degree of liquidity constrained households turn out insignificant. To check the robustness of these results we also combine the long- and short-run perspective in a co-integration model. Here we specify a Panel-ECM and look at its short run adjustment to judge about the share of liquidity constrained households. We find a significant but much lower fraction of constrained agents as in the earlier literature. Since we employ different estimators including (pooled) mean group estimation, we are also able to check for the asymmetry in the income-consumption path for German regions both with respect to the long and short run adjustment dynamics. Here we borrow from the literature on Poolability tests and search for macro regional clusters with similar adjustment paths. The findings show that for the sample of West German states between 1970 and 2006 both for short and long run parameters the assumption of poolability of the data cannot be rejected. However, we find a clear distinction in the short run path of the East German states since 1991 (which nevertheless converge to the same long run co-integration as the Western counterparts). One likely interpretation for the observed lower sensitivity of East German states to income shocks is the smoothening characteristics of income transfers to the East. As a robustness check we also apply the Panel-ECM with spatially filtered variables.

Suggested Citation

  • Timo Mitze, 2011. "Regional heterogeneity in consumption due to current income shocks: New evidence from the Permanent Income Hypothesis," ERSA conference papers ersa10p729, European Regional Science Association.
  • Handle: RePEc:wiw:wiwrsa:ersa10p729

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    References listed on IDEAS

    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. Georges Bresson & Badi H. Baltagi & Alain Pirotte, 2007. "Panel unit root tests and spatial dependence," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(2), pages 339-360.
    3. Joakim Westerlund, 2007. "Testing for Error Correction in Panel Data," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 69(6), pages 709-748, December.
    4. 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.
    5. Im, Kyung So & Pesaran, M. Hashem & Shin, Yongcheol, 2003. "Testing for unit roots in heterogeneous panels," Journal of Econometrics, Elsevier, vol. 115(1), pages 53-74, July.
    6. Joseph DeJuan & John Seater & Tony Wirjanto, 2006. "Testing the permanent-income hypothesis: new evidence from West-German states ( Länder)," Empirical Economics, Springer, vol. 31(3), pages 613-629, September.
    7. Jim Malley & Hassan Molana, 2006. "Further Evidence from Aggregate Data on the Life-Cycle-Permanent-Income Model," Empirical Economics, Springer, vol. 31(4), pages 1025-1041, November.
    8. 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.
    9. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
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