Testing the Response of Consumption to Income Changes


This paper tests the rational expectations lifecycle model of consumption
against (i) a simple Keynesian model and (ii) the rational expectations
lifecycle model with imperfect capital markets. The tests are based upon the
relative responsiveness of consumption to income changes which can be
predicted from past information and income changes which cannot be predicted.
Problems caused by measurement error in the income changes are circumvented by
using the innovations from a vector autoregression of the measures of the
determinants of income to form a noisy instrument for the unanticipated change
in incomÔ¨Ā and using the lagged values of the measures of the income
determinants to form an instrument for the anticipated income change. We show
that the Keynesian model implies that the regression coefficients relating the
change in consumption to the instruments for the anticipated and unanticipated
components of the income change should be equal. The lifecycle model (with
perfect capital markets) implies that only the instrument for the
unanticipated component should affect consumption. The empirical results
support the lifecycle model. In addition, we incorporate capital market
imperfections into our empirical formulation of the lifecycle model by
assuming that the marginal interest rate at a point in time is a
differentiable, concave function of net assets. This leads to a test for
capital market imperfections based upon whether consumption responds
differently to positive and negative predictable changes in income. Our
results are inconclusive.

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Quarterly Journal of Economics, vol. 102, no.2, May 1987
Working Papers