A Model of Expenditure Shocks

Abstract

We document four features of consumption and income in the post-1999 Panel Study of Income Dynamics: 1) household-level consumption is as volatile as household income on average, 2) household-level consumption growth has a positive but small correlation with income growth, 3) consumption growth is strongly negatively autocorrelated, and 4) the cross-sectional correlation between consumption growth and income growth is much lower among households experiencing high consumption (relative to their within-household average). To explain these facts we propose a model in which household expenditure depends on time-varying consumption thresholds where marginal utility discontinuously increases. Our model with consumption thresholds matches the facts better than does a standard model with or without measurement error. Poor households in our model also exhibit “excess sensitivity” to anticipated income declines.

Keywords: Consumption, Expenditure Shocks, Household Debt

JEL Classification: D14, E21