Looking for the News in the Noise - Additional Stochastic Implications of Optimal Consumption Choice

30 Pages Posted: 9 Jun 2004 Last revised: 1 Aug 2010

See all articles by Laurence J. Kotlikoff

Laurence J. Kotlikoff

Boston University - Department of Economics; National Bureau of Economic Research (NBER); Gaidar Institute for Economic Policy

Ariel Pakes

National Bureau of Economic Research (NBER); Harvard University - Department of Economics

Date Written: November 1984

Abstract

In neoclassical models of consumption choice under earnings uncertainty changes in consumption programs from one period to the next are determined by new information received about future earnings over the period. This proposition suggests testing the neoclassical model by ascertaining whether new earnings information explains consumption choice through time. It also suggests that actual consumption choices imbed extractable information about the extent and time resolution of earnings uncertainty. This paper derives a fairly general theoretical relationship between properly defined innnovations in consumption (noise) and revisions in expectations of lifetime earnings (news). It also clarifies the relationship between testing for the theoretical determinants of consumption and standard Euler tests that focus on theoretical nondeterminants of consumption. The chief prediction of the paper's theoretical results, that noise exactly equals news, is tested using aggregate time series data on consumption and earnings. We find that new earnings information explains only a very small fraction of the variance of aggregate consumption innovations. On the other hand, the extent of suboptimal consumption choice appears to be of little economic significance.

Suggested Citation

Kotlikoff, Laurence J. and Pakes, Ariel, Looking for the News in the Noise - Additional Stochastic Implications of Optimal Consumption Choice (November 1984). NBER Working Paper No. w1492. Available at SSRN: https://ssrn.com/abstract=334312

Laurence J. Kotlikoff (Contact Author)

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Ariel Pakes

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Harvard University - Department of Economics ( email )

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