Reconciling Consumer Confidence and Permanent Income Consumption

Abstract

The forecasting power of consumer confidence indexes for consumption spending runs counter to the predictions of the permanent income hypothesis (PIH). This paper resolves this discrepancy by developing a “confidence augmented” permanent income hypothesis (CAPIH). While it does not radically alter the estimated extent of permanent income consumption, the CAPIH model predicts a significantly smaller intertemporal elasticity of substitution than a standard PIH model. In addition, the results are largely invariant to the measure of consumer confidence used and the choice of instrumental variables.