Essays on consumption, excess sensitivity, and income uncertainty
In this work we consider the explanations for the rejection of the Rational Expectations-Life Cycle permanent Income Hypothesis (RE-LCPI Hypothesis), based on the finding of the "excess sensitivity" of consumption to current income. The excess sensitivity finding is well established for both time series and cross sectional data, however, the reasons for excess sensitivity are less well established. A prominent explanation for the observed excess sensitivity of consumption to income, is that capital market imperfections will prevent the consumer from borrowing and hence prevent the consumer from realising her desired consumption expenditure path (liquidity constraints). Competing explanations of excess sensitivity include myopia and precautionary savings' motives. Although some studies have cited particular reasons for the rejection of the RE-LCPI hypothesis, few studies have attempted to discriminate between the alternative explanations. This dissertation proposes to identify and discriminate between these alternative explanations using the Nordic countries (Finland, Norway and Sweden). The thesis is structured into four key chapters. Chapter Two identifies if consumption for Finland, Norway, and Sweden is excessively sensitive to changes in income, that is, is excess sensitivity evident for these countries. From the evidence of excess sensitivity found in chapter two, Chapter Three attempts to discriminate between two alternative explanations for excess sensitivity - myopia and liquidity constraints. Chapter Four draws on material in chapter three, and extends it in a new direction. From evidence of asymmetries in Chapter Three, this chapter attempts to analyse the source of the asymmetry, in particular, it examines if the asymmetry can be accredited to liquidity constraints or not. While Chapters Three and Four attempt to discriminate between alternative potential explanations for the excess sensitivity of consumption to income changes, by seeking to identify asymmetric behaviour of a kind consistent with optimising behaviour in the presence of liquidity constraints or in the absence of asymmetry as would be consistent with myopia, Chapter Five examines an alternative explanation: the potential mis-specification arising from the assumption of certainty equivalent. Specifically the potential role of uncertainty about future income in generating precautionary savings is examined within a two group aggregate consumption function.