WEALTH, DISPOSABLE INCOME AND CONSUMPTION - Economics

3 IS WEALTH USEFUL IN EXPLAINING
CONSUMPTION?
Reliable measures of aggregate human and non-human wealth are potentially
useful for addressing a broad range of macro issues, but perhaps
their most obvious application is in determining consumption and savings.
Specifically, one might ask, is measured wealth useful in explaining the
time-series behaviour of aggregate consumption?
An alternative model with a long tradition in macroeconomics is the
Keynesian consumption function that specifies consumption as a function
of disposable income. The usefulness of wealth in explaining consumption
is therefore evaluated relative to this alternative over both long and short
horizons. The long-run analysis examines the relationship between consumption,
wealth and disposable income using static linear regressions
and standard tests for cointegration. This long-run analysis then serves as a
precursor for the estimation of EC consumption equations designed to
explain the short-run dynamics of consumption around its long-run trend.
At the outset it is worth stressing that this approach to assessing the
usefulness of wealth is relatively stringent, since the disposable-income
and wealth-based consumption functions may be (nearly) observationally
equivalent. If innovations in disposable income are permanent or at least
very persistent, then most of the information regarding their future path,
and thus the information embodied in human wealth, is contained in the
current observations of disposable income. Indeed, using Monte Carlo simulations,
Davidson and Hendry (1981) have shown that Hall’s (1978) random-walk
model and the EC models developed by Davidson et al. (1978)
and Hendry and von Ungern-Sternberg (1981) are nearly equivalent.
Moreover, at a theoretical level, both Campbell (1987) and
Mitchener (1984) have demonstrated that a cointegrating relationship
between consumption and disposable income is consistent with the life
cycle–permanent income model. The results below cannot, therefore, be
viewed as definitive tests of the permanent income model. Rather, they
address the more modest question: Does measured wealth provide
23