How Forward Looking Are Consumers? Further Evidence for the United States.

• Author: Himarios, Daniel
• Position: Statistical Data Included

Daniel Himarios [*]

This paper extends a standard model of consumption to test for the existence of "myopic" consumers. The extended model includes "rule-of-thumb" consumers as well as consumers who are assumed to solve a dynamic programming problem. The model allows this second set of consumers, however, to be "boundedly rational." For a variety of reasons, they may be unable to fully account for their future uncertain labor income. The model predicts that this inability to correctly value future resources leads to the breakdown of the simple permanent income hypothesis and that consumption responds to predictable changes in income. Using data for the United States for the period 1951u1990, the paper finds evidence of such myopic behavior.

1. Introduction

   A considerable amount of research has found that the strict form of the LCuPIH (lifecycle, permanent-income hypothesis) is not supported by the data. Consumption appears to be "too sensitive" to predictable changes in income. There are several explanations in the literature for this failure, but a Keynesian "rule-of-thumb" behavior is the explanation that has received most of the attention.

   Campbell and Mankiw (1990) construct a model in which a fraction of income [lambda] accrues to individuals who, following "rules of thumb," consume their current income, while the remaining (1 - [lambda]) accrues to individuals who, being extremely farsighted, consume their permanent income. The rule-of-thumb behavior is subject to two interpretations (Shea 1995). One interpretation is that consumers are extremely "myopic." This nonoptimizing or myopic behavior implies that these consumers completely ignore their total wealth (or permanent income) when making consumption decisions. Another interpretation of the behavior of the first group of individuals is that they are liquidity constrained. These individuals have few or no real assets and have no access to capital markets. The empirical evidence from aggregate data is rather inconclusive, but evidence from more disaggregated data lends support to the liquidity constraints interpretation (Zeldes 1989a).

   While the CampbelluMankiw specification, under either interpretation, generates excess sensitivity and results in an empirically more realistic consumption function, its treatment of the second group of individuals, who are assumed to consume their permanent income, is unnecessarily restrictive. As Kotlikoff, Samuelson, and Johnson (1988, p. 408) point out, "A second problem that is also routinely swept under the rug involves the implicit assumption that consumers optimize perfectly given their preferences and resources, and that they correctly value their resources." Their results, based on experimental evidence, indicate that "subjects made significant and systematic errors in their consumption choice, reflecting, in part, an overdiscounting of future income" (p. 408). This "quasi-myopic behavior" has a variety of sources, such as high computational costs, habit, self-control, lack of extreme rationality or perfect farsightedness, short multiperiod planning horizons, and so on (Mariger 1986; Boskin 1988; S hefrin and Thaler 1988; Blanchard 1997, p. 151; Lettau and Uhlig 1999, among others), which can lead to failure by consumers to fully account for their future after-tax labor income. I will show that this behavior, which is consistent with a limited degree of myopia that might exist among those who are assumed to be extremely farsighted, can lead to excess sensitivity and the failure of the PIH. Lettau and Uhlig (1999) call these consumers "boundedly rational" (p. 152). Boskin (1988) and Poterba (1988) discuss the important implications for fiscal policy resulting from such myopic behavior.

   The evidence in favor of rule-of-thumb behavior in explaining consumption is too strong to ignore for empirical purposes (Dornbusch, Fischer, and Startz 1998, p. 308; Himarios 1995). Mariger (1986) argues that the failure to identify constrained and unconstrained consumers leads to models that are inherently misspecified. I will, therefore, use a specification that nests rules of thumb as a maintained hypothesis. The focus of the paper will be on the second set of consumers who are assumed to consume their permanent income, as in Campbell and Mankiw (1990). Based on the earlier discussion, I will relax this assumption and allow this set of maximizing consumers to behave in a "boundedly rational" manner.

   The paper proceeds as follows. In section 2, I briefly develop an empirically tractable consumption function and discuss the empirical implications of the model. In section 3, I discuss the data and the econometric methodology, and in section 4, I present the estimation results. The evidence is consistent with the existence of rule-of-thumb consumers, a result that has been documented in previous studies, and also consumers who exhibit myopia of the type suggested previously.

2. Theoretical Background

   Following Campbell and Mankiw (1990), I assume two types of households. Household type 1 behaves according to the LC-PIH. These consumers base their current consumption decisions on their lifetime resources, which consist of their financial wealth and the expected discounted value of their future after-tax labor income. A closed-form solution of this optimization problem is possible under certainty equivalence or under a quadratic utility function if income is assumed to be stochastic. Although quadratic utility can be justified on the grounds that it is a local approximation to the consumer's true utility function, its simplicity for computational problems is offset by serious shortcomings, and the resulting consumption function is likely to be severely misspecified (Hayashi 1982; Zeldes 1989b; Weil 1993). A more plausible utility function, assumed both by Hayashi and Zeldes, is the constant relative risk aversion function. Yet under such preferences and stochastic labor income, no closed-form solution is p ossible.

   One way, though an imperfect one, to take into account this labor income uncertainty and derive an approximate solution to the optimization problem is to allow households to discount their uncertain future labor income at a rate higher than the rate of interest (Hayashi 1982; Zeldes 1989b). The assumption that the discount rate exceeds the rate of interest is amply supported by previous evidence (Hayashi 1982; Graham and Himarios 1996, among others). The approximate solution to the type 1 consumer's optimization problem is then

   [C.sub.1,t] = [alpha][(1 + r)[W.sub.t-1] + [H.sub.1,t]], (1)

   where [W.sub.t-1] is the end-of-period nonhuman wealth held by these consumers (I assume that type 2 consumers hold no assets), [alpha] is the propensity to consume out of total wealth, and r is the nonstochastic real interest rate. The variable [H.sub.1,t] is the present discounted value of future after-tax labor income ([Y.sub.1,t]). If we assume that the share of after-tax labor income that accrues to these consumers is (1 - [lambda]), where [lambda] is the share of income accruing to type 2 consumers, then [H.sub.1,t] is defined as

   [H.sub.1,t] = [[[sum].sup.[infty]].sub.j=0] [(1 + [mu]).sup.-j][E.sub.t][Y.sub.1,t+j] = (1 - [lambda]) [[[sum].sup.[infty]].sub.j=0] [(1 + [mu]).sup.-j][E.sub.t][Y.sub.t+j], (2)

   where [E.sub.t] is the expectations operator conditional on information available in period t and [mu] is...