Are Consumers Forward-Looking?
30 Pages Posted: 26 Jun 2007
Date Written: June 25, 2007
Are consumers forward-looking? According to the certainty-equivalence version of the life cycle/permanent income hypothesis, consumption is a function of the expected present value of income. Using longitudinal data from the PSID, I invert this function and compare the realized present value of income to consumption. Consumption proves to be a very poor predictor of future income, despite future income being predictable by past income. Under rational expectations, information known to the consumer should not enter the regression of present value on consumption. However, as an empirical matter lagged income does enter. The conclusion is that consumers act as if they are not forward-looking. Available data being imperfect much of the paper is devoted to robustness tests, none of which change the basic conclusion.
Keywords: consumption, forward-looking behavior, rational expectations, PSID
JEL Classification: E21
Suggested Citation: Suggested Citation