Subjective Data in a Test of the Life Cycle Model

Abstract

The life cycle model is a cornerstone model in modern micro– and macro economics. The life cycle model offers a rationale for savings behavior, as individuals or households are assumed to value future utility in current period decisionmaking. A frequently employed test on the validity of the life cycle model is based on the orthogonality conditions implied by the first order condition of the problem: the Euler equation of consumption (Hall 1978). Such tests are convenient as they do not rely on a specification of income processes for example. Conventional approaches subsequently define preferences (i.e., the marginal rate of substitution between future and current consumption) and test the empirical validity of this –one specific– parameterization of the model. In this paper I propose “self-reported changes in food consumption adequacy” as a direct proxy for the marginal rate of substitution of food consumption in two consecutive periods. Indonesian households were asked to rate the change in the adequacy of food consumption from a year ago until now on a five-point scale. The methodology has two clear advantages over conventional approaches. First, the test does not rely on ex ante specified preferences, such that it scrutinizes the validity of a life cycle model of unknown form (e.g., habit formation, within period nonseparabilities, etc. are implicitly allowed for). 1 Secondly, conventional tests may suffer from low power as it can be difficult to statistically distinguish an “extended life cycle model” from alternative theories of behavior. In this paper, I strongly reject the life cycle model with constant discount rates. The model with house