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Consumption Theory
Handbooks in Central Banking

No. 23

CONSUMPTION THEORY

Emilio Fernandez-Corugedo

Series editors: Andrew Blake & Gill Hammond
Issued by the Centre for Central Banking Studies,
Bank of England, London EC2R 8AH
E-mail: ccbsinfo@bankofengland.co.uk
July 2004
© Bank of England 2004
ISBN 1 85730 143 9

Consumption Theory
Emilio Fernandez-Corugedo1
Centre for Central Banking Studies, Bank of England

1

This Handbook represents the views and analysis of the author and should not be thought to represent those of the Bank of England or Monetary Policy Committee members. The Handbook is a modified chapter from my Bristol University PhD thesis ‘Essays on Consumption’. I would like to thank my PhD advisers
Cliff Attfield, Nigel Duck and David Demery for their insights. Suggestions from Andrew Benito, Andrew
Blake, Gill Hammond and Paul Robinson greatly improved the Handbook. All errors and omissions remain, of course, my responsibility.

Contents
1 Introduction

2

2 Consumption: key theories and terminology
2.1 The absolute income hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 The permanent income hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3 The life cycle hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2
2
3
5

Box A: Understanding consumption terminology

6

3 Rational expectations, unit roots and poor forecasting

9

4 The rational expectations permanent income hypothesis

10

Box B: The impact of interest rates on consumption

12

Box C: The role of assumptions in REPI

13

5 Departing from REPI
5.1 Breaking certainty equivalence: precautionary saving . . . . . . . .
5.1.1 The buffer stock model . . . . . . . . . . . . . . . . . . . .
5.2 Near rationality and aggregation . . . . . . . . . . . . . . . . . . .
5.2.1 Near rationality and the updating of consumption decisions
5.2.2 Near rationality and imperfect information . . . . . . . . .
5.3 Liquidity constraints . . . . . . . . . .



References: [1] Abel, A. B. (1990), ‘Asset prices under habit formation and catching up with the Joneses’, American Economic Review, 40, pp [2] Akerlof, G. A. and Yellen, Y. L. (1985), ‘Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?’, American Economic Review, 75, pp. 708-720. [3] Allen, T. A. and Carroll, C. D. (2001), ‘Individual Learning About Consumption’, Macroeconomic Dynamics, 5, pp. 255-71. [4] Arreaza, A. (2003), ‘Liquidity Constraints and Excess Sensitivity of Consumption in Latin American Countries’, mimeo, Central Bank of Venezuela. [5] Arrow, K. J. (1965), ‘Aspects of a Theory of Risk Bearing’, Yrjo Jahnsson Lectures, Helsinki. Reprinted in Essays in the Theory of Risk Bearing (1971). Markham Publishing Co. [6] Attanasio, O. P. (1998), ‘Consumption Demand’, NBER Working Paper No. 6466. [7] Attanasio, O. P., and Weber, G. (1993), ‘Consumption Growth, the Interest Rate, and Aggregation’, Review of Economic Studies, 60, pages 631-649. [8] Bakhshi, H. (2000), ‘The sensitivity of aggregate consumption to human wealth’, Bank of England Working Paper No 108. [9] Borooah, V. K. and Sharpe, D. R. (1986), ‘Aggregate Consumption and the Distribution of Income in the United Kingdom: An Econometric Analysis’, Economic Journal, 96, pp [10] Browning, M. and Lusardi, A. (1996), ‘Household Saving: Micro Theories and Macro Facts’, Journal of Economic Literature, XXXIV, pp [11] Caballero, R. J. (1990a), ‘Consumption Puzzles and Precautionary Saving’, Journal of Monetary Economics, 25, pp. 113-36. [12] Caballero, R. J. (1990b), ‘Expenditure on durable goods: a case for slow adjustment’, Quarterly Journal of Economics, 105, pp [13] Caballero, R. J. (1993), ‘Durable Goods: An Explanation for their Slow Adjustment’, Journal of Political Economy, 101, pp [14] Caballero, R. J. (1994), ‘Notes on the Theory and Evidence on Aggregate Purchases of Durable Goods’, Oxford Review of Economic Policy, 10, pp [15] Caballero, R. J. (1995), ‘Near Rationality, Heterogeneity and Aggregate Consumption’, Journal of Money, Credit, and Banking, 27, pp. 29-48. [16] Campbell, J. Y. (1987), ‘Does Saving Anticipate Declining Labour Income? An Alternative Test of the Permanent Income Hypothesis’, Econometrica, 55, pp [17] Campbell, J. Y. and Cochrane, J. H. (1999), ‘By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior’, Journal of Political Economy, 107, pp. [20] Carroll, C. D. (1992), ‘The Buffer Stock Theory of Saving: Some Macroeconomic Evidence’, Brookings Papers on Economic Activity, 2, pp [21] Carroll, C. D. (1997). ‘Buffer stock saving and the life cycle/permanent income hypothesis’, The Quarterly Journal of Economics, CXII, pp [22] Carroll, C. D. (2000a), ‘Solving consumption models with multiplicative habits,’ Economics Letters, 68, pp [23] Carrol C. D. (2000b), ‘Requiem for the Representative Consumer? Aggegate Implications of Microeconomic Consumption Behaviou’, American Economic Review, Papers and Proceedings, [24] Carroll, C. D. (2000c) ‘ ‘Risky Habits’ and the Marginal Propensity to Consume Out of Permanent Income’, International Economic Journal, 14, pp [25] Carroll, C. D. (2001a), ‘Precautionary Saving and the Marginal Propensity to Consume Out of Permanent Income’, NBER Working Paper Number W8233. [26] Carroll, C. D. (2001b), ‘A Theory of the Consumption Function, With and Without Liquidity Constraints’, Journal of Economic Perspectives, 15, pp 23-46. [27] Carroll, C. D. (2001c), ‘A Theory of the Consumption Function, With and Without Liquidity Constraints (Expanded Version)’, NBER Working Paper W8387. [28] Carroll, C. D. and Dunn, W. E. (1997), ‘Unemployment Expectations, Jumping (S,s) Triggers, and Household Balance Sheets‘ in NBER Macroeconomics Annual, 1997, Bernanke, B [29] Carroll, C. D. and Kimball, M.S. (1996), ‘On the concavity of the consumption function’, Econometrica, 64, pp [30] Carroll, C. D., Overland, J. R. and Weil, D. N. (2000), ‘Saving and growth with habit formation’, American Economic Review, 90, pp. 341-55. [31] Carroll, C. D. and Weil, D. N. (1994), ‘Saving and Growth: A Reinterpretation’, CarnegieRochester Conference Series on Public Policy, 40, pp. 133-92. [32] Chiang, A. C. (1984), Fundamental methods of mathematical economics, third edition. [33] Chiang, A. C. (1992), Elements of dynamic optimisation. McGraw-Hill. [34] Clarida, R. H. (1991), ‘Aggregate Stochastic Implications of the Life Cycle Hypothesis’, Quaterly Journal of Economics, 106, pp [35] Cochrane, J. H. (1989), ‘The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives’, American Economic Review, 79, pp. 319-37. [36] Constantinides, G. R. (1990), ‘Habit Formation: A Resolution of the Equity Premium Puzzle’, Journal of Political Economy, 98, pp [38] Davidson, J. E. H., Hendry, D. F., Srba, F.. and Yeo, S. (1978), ‘Econometric Modelling of the Aggregate Time-Series Relationship between Consumers’ Expenditure and Income in the [39] Deaton, A. (1987), ‘Life-Cycle Models of Consumption: Is the Evidence Consistent with the Theory?’, in Bewley, T [40] Deaton, A. (1991), ‘Saving and liquidity constraints’, Econometrica, 59, pp. 1121-1142. [41] Deaton, A. (1992), Understanding consumption. Clarendon Press. [42] Dixit, A. K. (1990), Optimisation in economic Theory, second edition. Oxford University Press. [43] Elmendorf , D. W. (1996), ‘The effect of interest-rate changes on household saving and consumption: A Survey’, mimeo, Federal Reserve Board. [44] Fernandez-Corugedo, E. W. (2000), Essays on Consumption, Unpublished PhD Thesis, University of Bristol. [45] Fernandez-Corugedo E. W. (2002) ‘Soft liquidity constraints and precautionary saving’, Bank of England Working Paper 158. [46] Fischer, I. (1930), The Theory of Interest. New York: Macmillan. [47] Flavin, M. (1981), ‘The Adjustment of Consumption to Changing Expectations About Future Income’, Journal of Political Economy, 89, pp [48] Friedman, M. (1957), A Theory of the Consumption Function. Princeton University Press. [49] Furher, J. C. (2000), ‘Habit formation in consumption and its implications for monetary policy models’, American Economic Review, 90, pp [50] Hall, R. E. (1978), ‘Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence’ Journal of Political Economy, 86, pp [51] Hamilton, J. D. (1994), Time Series Analysis, Princeton University Press. [52] Hansen, L. P. and Sargent, T. J. (1981), ‘A Note on Wiener-Kolmogorov Forecasting Formulas for Rational Expectations Models’, Economic Letters, 8, pp [53] Hendry, D. F. and Von ungern-Sternberg, T. (1981), ‘Liquidity and Inflation Effects on Consumers’ Expenditure’. In Essays in The Theory and Measurement Of Consumer Behaviour, Deaton, A [54] Gali, J. (1994), ‘Keeping up with the Joneses: Consumption externalities, portfolio choice and

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