Empirical evidence on consumption smoothing and intergenerational transfers.

• Author: Kan, Kamhon

1. Introduction

   In this study, I examine empirically intergenerational linkage in terms of resources transfers in the extended family. In particular, conditional on a household's and its parents' (or children's) liquidity constraints status, I look at how far the household can smooth its consumption in face of negative income shocks.

   The permanent income hypothesis postulates that households make their consumption decisions based on their lifetime resources. Thus, their consumption trajectory follows a smooth path in face of shocks to their income. However, in various tests [8; 10] the unconditional form of the hypothesis has been rejected. It is conjectured and generally agreed that the rejections of the hypothesis are mainly due to the presence of liquidity constraints (i.e., capital market imperfections) (see Zeldes [22] for a recent empirical investigation and Hayashi [12] for an excellent survey). Moreover, the works by Cochrane [4] and Mace [19] further confer cogency on the liquidity constraints/capital market imperfections argument. In testing whether households have full consumption insurance (or, equivalently, the existence of complete markets) against idiosyncratic shocks, they reject their null of the existence of full consumption insurance in some of their tests.

   The presence of missing markets may give rise to non-market institutions. The extended family, being the most intimate group/institution related to a household, is most likely to provide a means for consumption insurance. The works by Cox [5], Cox and Jappelli [6], and Guiso arid Jappelli [9] (all of whom use micro data with direct observation on intergenerational transfers) explore this possibility. Their findings provide supports that liquidity constrained households are likely to receive intergenerational transfers. However, it is found that there is still a large fraction of liquidity constrained households who do not receive transfers. And among those who received transfers, most of them still cannot completely overcome liquidity constraints. It is likely that the far-from-overwhelming alleviating effect of intergenerational transfers on the liquidity constrained households is attributable to the absence of linkage to the liquidity unconstrained households.

   Approaching the issue differently, Able and Kotlikoff [1] (using data from Consumer Expenditure Survey) and Altonji, Hayashi, and Kotlikoff [3] and Hayashi, Altonji, and Kotlikoff [13] (both using data from the PSID) examine the existence of complete income pooling in the context of the extended family. Complete income pooling by all members of an extended family implies a single budget constraint for the extended family. Their results are mixed. While Able and Kotlikoff [1] accept the hypothesis of complete income pooling,(1) Hayashi, Altonji and Kotlikoff [13] and Altonji, Hayashi, and Kotlikoff [3] reject it. However, the bottom line is that their results do not reject the notion that members in an extended family are altruistically linked, even though apparently the linkage is not as strong as that implied by complete income pooling.

   Based on the empirical results of the above mentioned studies, it appears that households in an extended family are linked. However, intergenerational transfers are found to have only minimal impact on relieving households of liquidity constraints. Also, the linkage between households seems to be brittle. These findings are inconsistent with those obtained by Kotlikoff [15] and Kotlikoff and Summers [16; 17; 18] who find that intergenerational transfers (in the form of bequests) are quantitatively significant (accounting for the accumulation of almost 80% of the U.S. private net wealth).(2) Seemingly, part of the picture is obscured by failing to account for the financial status and consumption behavior of the households which a household in question is linked to.

   In this paper, the issue being addressed is the interactions among inter vivos intergenerational transfers (between parents and their children), consumption smoothing and liquidity constrained. On ground of the existing empirical findings, it is likely that households belonging to the same extended family are linked through resource transfers with operativeness and/or effectiveness of the linkage being dependent on the financial status of the involved households. The objective of this paper is to empirically explore the significance of intergenerational transfers on consumption smoothing and their interactions with liquidity constraints.

   The effectiveness of intergenerational transfers as a means of consumption insurance rests on the liquidity constraint (i.e., financial) status of the member households in an extended family. In the context of an extended family, whether a household itself is liquidity constrained and whether the household is linked to a liquidity constrained or a liquidity unconstrained household may bear strikingly different implications on its ability to insure itself against income shocks. In this study, in examining the consumption insuring effect of intergenerational transfers against idiosyncratic shocks, the liquidity constraint status of both a household and its parents' households are taken into consideration. The present paper could be regarded as an extension of Cochrane [4] and Mace [19] with consumption insurance being provided by the extended family instead of the whole economy or as an extension of Able and Kotlikoff [1], Altonji, Hayashi, and Kotlikoff [3], and Hayashi, Altonji, and Kotlikoff [13], with the degree of intergenerational altruism being restricted (that is, instead of assuming a single budget constraint for the whole extended family, i.e., complete income pooling, separate budget constraints with interdependent utilities are proposed). The empirical work in this paper is based on panel data from the Panel Study of Income Dynamics (PSID). In the data, children who were residing with their parents during the initial survey year (1968) but went out to form their own households are matched with their parents in recent survey years (1984-1987).

   The organization of the remaining part of the paper is as follows. A model describing the interactions among intergenerational transfers, liquidity constraints and consumption behavior is presented in section II. In section III the framework of the empirical work is described. The data used in this study are explained in section IV which is followed by a discussion of the estimation results in section V. Finally, the summary and conclusion of the paper are given in section VI.

2. The Model

   In this section, I explore a model, which helps to illustrate the interactions between intergenerational transfers and liquidity constraints within an extended family, and its implications on the pattern of consumption in the presence of income shocks. In the model we have two agents, a parent and a child, who are infinitely lived and are mutually altruistic to each other. Intergenerational altruism is parametrized as interdependence of a parent's and her child's utilities. The parent and the child (in an extended family), respectively, at the beginning of their life face the lifetime (expected) utility maximization problems:

   [Mathematical Expression Omitted],

   subject to:

   [Mathematical Expression Omitted];

   and

   [Mathematical Expression Omitted],

   subject to:

   [Mathematical Expression Omitted].

   where:

   [Mathematical Expression Omitted] = consumption of the parent (i.e., f = p) or the child (i.e., f = k),

   [Mathematical Expression Omitted] = saving of the parent (i.e., f = p) or the child (i.e., f = k),

   [b.sub.t] = money transfers from a parent to her child,

   [g.sub.t] = money transfers from a child to her parent,

   [Delta] = intertemporal discount rate,

   [[Beta].sub.p], = a child's discount rate of her parent's utility,

   [[Beta].sub.k] = a parent's discount rate of her child's utility,

   [V.sup.*] = maximum attainable lifetime utility of a parent,

   [U.sup.*] = maximum attainable lifetime utility of a child,

   u([center dot]) = per period utility function with u[prime]([center dot]) [greater than] 0, u[double prime]([center dot]) [less than] 0, [lim.sub.c[approaches]0] u[prime](c) = [infinity] and [lim.sub.c[approaches][infinity]]u[prime](c) = 0,

   [Mathematical Expression Omitted] = the parent's (i.e., f = p) or the child's (i.e., f = k) income which is stochastic and expectation error are serially independent, and

   r = per period interest rate which is assumed to be constant.

   The source of uncertainty that an agent faces comes from the stochastic nature of income at each period. It is assumed that the shocks in income are of zero mean and serially uncorrelated. In this economy, agents cannot hold negative asset at any point in time. That is, liquidity constraints exist in the form of borrowing constraints and agents have to maintain a non-negative asset holding, i.e., [Mathematical Expression Omitted], f = p, k. The Nash assumption is adopted in the model, so that both a parent and her child take each other's decision as given (as is common in this type of analysis).

   At the beginning of each period, an agent obtains an income, [Mathematical Expression Omitted], which together with the stock of saving from the previous period, [Mathematical Expression Omitted], are to be allocated to consumption, [Mathematical Expression Omitted], saving, [Mathematical Expression Omitted], and transfers to her parent, [g.sub.t], or transfers to her child, [b.sub.t]. In this model negative transfers are not allowed. (As shown by Kimball [14], stability of equilibrium in a dynamic model requires [[Beta].sub.p][[Beta].sub.k] [less than] 1/4 which implies that [b.sub.t] and [g.sub.t] cannot be simultaneously positive.)

   The maximization problems (1) and...