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The Slow Adjustment of Aggregate Consumption to Permanent Income

Authors


  • This paper has previously circulated under the title “The Behaviour of Aggregate Consumption According to Cointegration Analysis with Correlated Unobserved Components.” The author would like to thank Richard Clarida, Bill Crowder, Steve Fazzari, Ed Greenberg, Charles Nelson, Jeremy Piger, Robin Sickles, Tara Sinclair, Dick Startz, Mark Wohar, and seminar participants at Washington University, the University of Houston, the Federal Reserve Bank of New York, the Bank of Canada, and Southern Illinois University Carbondale, and participants at the “State-Space Models, Regime Switching, and Identification” workshop held at Washington University for helpful comments and discussions. Support from the Weidenbaum Center on the Economy, Government, and Public Policy is gratefully acknowledged. The usual disclaimers apply.

Abstract

This paper investigates the relationship between aggregate consumption and permanent income using a new approach to the estimation of cointegrated systems that builds on Stock and Watson's common stochastic trends representation. The permanent and transitory movements in aggregate income and consumption are estimated directly using the Kalman filter and are allowed to be correlated. This approach avoids any implicit restriction that permanent income be as smooth as consumption. Instead, permanent income appears to be relatively volatile, with consumption adjusting toward it only slowly over time. These results provide a clear rejection of the standard version of the permanent income hypothesis and are suggestive of alternative theories of consumption behavior such as habit formation or precautionary savings.

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