Myopia, Liquidity Constraints, and Aggregate Consumption: A Simple Test
Journal article by John Shea; Journal of Money, Credit & Banking, Vol. 27, 1995
Journal Article Excerpt
Myopia, liquidity constraints, and aggregate consumption: a simple test. by John Shea THE NEOCLASSICAL life cycle--permanent income hypothesis (LCH/PIH) implies that predictable movements in income should not affect consumption. Recent tests using aggregate time-series data consistently reject this prediction. Campbell and Mankiw (1990), for instance, present significant estimates of the elasticity of consumption with respect to predictable income ranging from 0.351 to 0.713. While the failure of the LCH/PIH in aggregate data is well established, the reason for this failure is not. Two alternative hypotheses that have received considerable attention are myopia and liquidity constraints. This note conducts a simple test of these two alternatives using aggregate time series data.(1) The test exploits the fact that myopia and liquidity constraints have testable implications for asymmetry in consumption behavior, as first noted by Altonji and Siow (1987). Under myopia, consumption tracks current income. Thus, the failure of the LCH/PIH should be symmetric: consumption should respond equally to predictable income increases and decreases. Under liquidity constraints, however, the LCH/PIH fails only because agents cannot borrow when income is temporarily low. In this case, consumption should be more strongly correlated with predictable income increases than declines; liquidity constraints impede borrowing but not saving. The empirical evidence suggests that neither myopia nor liquidity constraints is an adequate characterization of U.S. aggregate consumption behavior. Using quarterly data from 1956-1988, I show that consumption is more sensitive to predictable income declines than increases. This "perverse asymmetry" also arises in my recent study of household consumption (Shea 1995). These findings are inconsistent with myopia and liquidity constraints, but are qualitatively consistent with recent work incorporating loss aversion into intertemporal preferences. 1. SPECIFICATION, DATA, AND RESULTS Following Campbell and Mankiw (1990; hereafter Campbell-Mankiw), one can test the LCH/PIH by running the following OLS regression: [MATHEMATICAL EXPRESSION OMITTED] where [delta]c is consumption growth between t - 1 and t, [delta]y is expected income growth between t - 1 and t, and r is the expected real interest rate between t - 1 and t. Under the LCH/PIH, predictable income movements should not affect consumption, controlling for the return to saving. Thus, under the LCH/PIH [lambda] should equal zero, provided [delta][y.sub.t] and [r.sub.t] are measured using information available at t - 1. Following Campbell-Mankiw, I set [delta][y.sub.t] and [r.sub.t] as linear projections of ex post income growth and the ex post real interest rate on variables in the t - 1 information set. Under myopia, consumption tracks current income. Consumption should respond symmetrically to predictable income increases and decreases. Under liquidity constraints, however, consumption should respond more strongly to predictable income increases than decreases; liquidity constraints do not cause the Euler equation between adjacent periods to fail if optimal frictionless consumption growth exceeds expected income growth.(2) This discussion suggests that one can test for the presence of liquidity constraints and myopia by running the following OLS regression: [MATHEMATICAL EXPRESSION OMITTED] where POS is a dummy variable for periods in which [delta]y > 0, and NEG is a dummy variable for periods in which [delta]y < 0. Under the LCH/PIH, both [[lambda].sub.1] and [[lambda].sub.2] should equal zero. Under myopia, the [lambda]s should be positive, significant, and equal. With liquidity constraints, [[lambda].sub.1] should be significantly positive, and should be significantly greater than [[lambda].sub.2]. For the sake of robustness, I estimate (1) and (2) on two data sets. In the first set, consumption equals quarterly seasonally adjusted per capita real NIPA personal consumption expenditures (PCE) on nondurables and services. Income equals quarterly seasonally adjusted per capita real NIPA disposable personal income, deflated using the PCE deflator for all consumption. The (ex post) real interest rate equals the average secondary market three-month nominal T-bill yield in period t - 1 minus the growth rate of the PCE deflator for all consumption between t - 1 and t.(3) In the second data set, I follow the advice of Blinder and Deaton (1985) by removing the 1975:2 income tax rebate and interest payments from households to businesses from disposable income, and by removing shoes and clothing from nondurables consumption.(4) The sample period is 1956:4 through 1988:4, a total of 129 observations. To form [delta][y.sub.t] and [r.sub.t], I experiment with five lists of instruments, shown in Table 1. These lists include lags of income growth, consumption growth, interest rates, and the log consumption--income ratio; Campbell-Mankiw use similar instruments.(5) [TABULAR DATA OMITTED]Empirical results using the standard NIPA data are shown in Table 2; Table 3 presents results using the Blinder-Deaton data. In each table, column (1) presents ... |
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