Can Buffer Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?

Abstract

The buffer-stock model of precautionary saving has become a workhorse of modern-day consumer theory. Despite its growing popularity, virtually no research has set out to formally investigate whether buffer-stock behavior can replicate the well-known smoothness of aggregate consumption growth ("excess smoothness"), or its correlation with lagged income ("excess sensitivity"). We investigate an aggregate version of the standard buffer stock model and examine how its predictions vary according to whether individuals observe economy-wide variation in their income. Our results show that, when individuals observe each component of their income, aggregate buffer stock consumption growth is at least as volatile as aggregate income growth and insignificantly correlated with lagged income growth. We show that adding incomplete information about aggregate income goes part of the way toward resolving these discrepancies, but still falls short of matching the data in magnitude. In particular, buffer stock saving creates a smoothness puzzle for aggregate consumption that remains to be explained.

JEL Classification: D11, D91, E21