Individual Income, Incomplete Information, and Aggregate Consumption


Individual income is much more variable than aggregate per capita income. I argue that aggregate information is
therefore not very important for individual consumption decisions and construct a model of life-cycle consumption in
which individuals react optimally to their own income process but ignore economy wide information. Since individual
income is less persistent than aggregate income consumers will react too little to aggregate income variation. Aggregate
consumption will be excessively smooth. Since aggregate information is slowly incorporated into consumption,
aggregate consumption will be autocorrelated and correlated with lagged income. On the other hand, the model has
the same prediction for micro data as the standard permanent income model. I argue that this is roughly in accord with
the findings in the literature.
The second part of the paper provides empirical evidence on individual and aggregate income processes and calibrates
the model using the estimated parameters. The model predictions roughly correspond to the empirical findings for
aggregate consumption. Allowing for the existence of measurement error in micro income, durables, finite lifetimes
of consumers, and advance information improves the predictions of the model. These features introduce relatively
small changes as compared to the impact of incomplete information.

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Econometrica , Vol. 63, No. 4, July, 1995
Working Papers