Precautionary Saving and Consumption Fluctuations
Woodrow Wilson School Economics Discussion Paper No. 227
35 Pages Posted: 7 Apr 2004
Date Written: March 2004
This paper uses the consumption Euler equation to derive a decomposition of consumption growth into four sources. These are new information and three sources of predictable consumption growth: intertemporal substitution, changes in the preferences for consumption, and incomplete markets for consumption insurance. Using data on the expenditures of households, we implement the decomposition for the average growth rate of consumption expenditures on nondurable goods in the U.S. from the beginning of 1982 to the end of 1997. Incomplete markets for trading consumption in future states lead to statistically significant and countercyclical movements in expected consumption growth: consumption growth is expected to be higher when the unemployment rate is high. The economic importance of precautionary saving rivals that of the real interest rate, but the relative importance of each source of movement in the volatility of consumption is not precisely measured.
Keywords: Incomplete markets, precautionary saving, permanent income hypothesis, business cycles, consumption smoothing, Euler equation
JEL Classification: E21, E32, D12
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