The excess smoothness puzzle in consumption

Abstract

This paper discusses the puzzle which means that permanent income is more volatile than consumption. There have been two major explanations of this puzzle. One is that the existence of excess sensitivity spreads the effect of a permanent income innovation over multiple periods. The other is that a significant transitory income component which is independent with permanent income implies a much smoother permanent income than a univariate labor income process predicts;Two questions are suggested. The first one is whether excess smoothness is an independent phenomenon of excess sensitivity. Quah (1990) indicates that the existence of a transitory component of labor income can resolve this puzzle. However, this paper criticizes this by arguing that his idea implies too small a covariance between the first differences of observed consumption and labor income;The second question is that there is significant difference in measured volatility of permanent income between when a simple ARIMA representation of labor income process is applied to Flavin's permanent income and when a nonparametic approach is applied to Gali's alternative formulation. This paper constructs a general model which embodies not only the two formulations of permanent income but also the existence of excess sensitivity and bivariate labor income process which have been suggested as possible explanations for excess smoothness;From empirical analysis, we conclude that these factors can not explain the difference between the two formulations. The transitory component of labor income does not significantly decrease the volatility of Flavin's permanent income, and excess sensitivity probably can not fully explain excess smoothness.