Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?

Abstract

One of the lasting contributions to modernday consumer theory is the idea that consumption is determined by the expected value of lifetime resources, or permanent income. The modern-day specification of this concept is typically presented as a special case of intertemporalchoice theory, where felicity functions are quadratic, labor income is stochastic, there are no restrictions on borrowing, consumers have infinite horizons, and expectations are formed rationally. We refer to this model as the permanentincome hypothesis (PIH). Although the PIH has considerable intuitive appeal, a series of influential papers published after its inception revealed two notable discrepancies between the model's predictions and aggregate data. First, the model predicts that consumption growth should be more volatile than income growth if aggregate income growth has positive serial correlation (as the quarterly data suggest it does), yet aggregate consumption growth is in fact much smoother than aggregate income growth (Angus Deaton, 1987; John Y. Campbell and Deaton, 1989; Jordi Gali, 1991). Second, the PIH predicts that consumption changes should be orthogonal to predictable, or lagged, income changes, yet the coffelation between consumption growth and lagged income growth has been found to be one of the most robust features of aggregate data (for example, Marjorie A. Flavin, 1981; Alan S. Blinder and Deaton, 1985; Campbell and N. Gregory Mankiw, 1989; Orazio P. Attanasio and Guglielmo Weber, 1993). Thus aggregate consumption growth has been described as exhibiting two puzzles: it is both excessively smooth relative to current labor-income growth, and excessively sensitive to lagged labor-income growth. 2 In response to these and other empirical anomalies, researchers have recently sought out modifications of the PIH framework. Chief * Ludvigson: Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045; Michaelides: University of Cyprus, P.O. Box 20537, 1678 Nicosia, Cyprus. A previous version of this paper appeared under the title Can We Explain the Consumption Excesses Yet? Aggregate Consumption Implications of Buffer Stock Saving Behavior. For many helpful comments, we thank Orazio Attanasio, Dave Backus, Ben Bernanke, John Y. Campbell, Christopher Carroll, Todd Clark, Angus Deaton, PierreOlivier Gourinchas, Bo Honore, James Kahn, Martin Lettau, Costas Meghir, Christina Paxson, Steve Pischke, Andrew Samwick, Christopher Sims, Mark Watson, Guglielmo Weber, Michael Woodford, Steve Zeldes, and two anonymous referees, conference participants at the National Bureau of Economic Research Summer Workshop on the Aggregate Implications of Microeconomic Consumption Behavior, July 1998, the TMR Workshop on Saving and Pensions-CenTER, Tilburg University, March 1999, and the New York Area Macroeconomics Workshop, October 1998, seminar participants at Columbia University, INSEAD, the New York Federal Reserve, University College London, London Business School, City University Business School, University of Cyprus, Tel Aviv University, and Jeffrey Brown for excellent research assistance. The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. 1 Note that the important insight of Danny Quah (1990), that individuals may be better able than econometricians to distinguish short-run from long-run innovations to their income, cannot resolve the excess-smoothness puzzle laid out in Campbell and Deaton (1989). These authors show that-in the context of the PIH excess sensitivity and excess smoothness are the same phenomena. In addition, Campbell (1987) demonstrates that superior information of the type emphasized by Quah will show up in households' saving behavior, and using this information allows the econometrician to control for the agent's private information when predicting income. Since excess sensitivity is well established, and controlling for saving does not eliminate it (see Campbell and Deaton, 1989), the observed smoothness of consumption cannot be explained by superior information on the part of permanent-income consumers. See Deaton (1992) for further discussion. 2 Philippe Bacchetta and Stefan Gerlach (1997) and Ludvigson (1999) document another kind of excess sensitivity: the correlation between consumption growth and predictable changes in consumer credit. Although we do not explore these findings here, Ludvigson finds that a bufferstock model with time-varying liquidity constraints can replicate such a correlation.