Abstract
This paper investigates whether there is a fraction of consumers that do not behave as fully forward-looking optimal consumers in the Brazilian economy. The generalized method of moments technique was applied to nonlinear Euler equations of the consumption-based capital assets model contemplating utility functions with time separability and non-separability. The results show that when the household utility function was modeled as constant relative risk aversion, external habits and Kreps-Porteus, estimates of the fraction of rule-of-thumb households was, respectively, 89%, 78% and 22%. According to this, a portion of disposable income goes to households who consume their current incomes in violation of the permanent income hypothesis.
Highlights
The permanent income hypothesis (PIH), described by Friedman (1957), states that transitory changes in income have little effect on consumer spending, while permanent income is responsible for most of the variation in consumption
Using log-linearization of the model and instrumental variable estimates, they established by empirical application that there was a strong violation of the permanent income hypothesis because a significant fraction of the households have suboptimal behavior
There was a strong violation of the permanent income hypothesis
Summary
The permanent income hypothesis (PIH), described by Friedman (1957), states that transitory changes in income have little effect on consumer spending, while permanent income is responsible for most of the variation in consumption. Flavin (1981), using a rational expectations structure, argued that consumption is sensitive to current income and it is greater than that predicted by the permanent income hypothesis This conclusion has been widely interpreted as evidence of the existence of liquidity constraint. Empirical evidence shows that liquidity constraint is one of the main reasons why it is difficult to observe consumption smoothing in the data Based on this evidence, Campbell & Mankiw (1989, 1990) suggested that aggregated data on consumption would be better characterized if there were two types of consumers. Using log-linearization of the model and instrumental variable estimates, they established by empirical application that there was a strong violation of the permanent income hypothesis because a significant fraction of the households have suboptimal behavior
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