WEALTH, DISPOSABLE INCOME AND CONSUMPTION - Economics

1 INTRODUCTION
Empirical research on consumption behaviour over the past 15 or so years
has been strongly influenced by two papers, both published in 1978. Hall
(1978) examined the stochastic implications of the permanent income
hypothesis, and Davidson et al. (1978) developed dynamic econometric
models for aggregate consumption based on an error-correction (EC)
specification.
Hall’s innovation was to exploit the restrictions implied by the firstorder
conditions of a representative consumer’s intertemporal optimization
problem. The attractive feature of this approach is that the resulting
Euler equations do not require the specification of all future variables relevant
to the household’s consumption decisions, so the difficulties associated
with measuring wealth and obtaining closed-form relationships
between consumption and wealth can be largely avoided.
These advantages are, however, achieved at some cost. While the
estimation of Euler equations allows the empirical researcher to examine
whether consumers adjust optimally between adjacent periods, it provides
little direct evidence on the determinants of consumption or on how various
random disturbances or policy changes are transmitted to consumption.
Consequently, the Euler equation approach to modelling
consumption is not particularly well-suited to policy analysis and forecasting.
In addition, the stochastic permanent income model also suffers the
practical problem that it is frequently rejected by the data (see, for example,
Flavin 1981, Hayashi 1982, Nelson 1987, and Wirjanto 1991). These rejections
are often interpreted as evidence that some consumers face binding
liquidity constraints (see Hall and Mishkin 1982, Flavin 1985, Zeldes 1989,
and Campbell and Mankiw 1990).
Partly as a result of these limitations, policy makers and practitioners
in general have largely turned to the more eclectic EC consumption
model proposed by Davidson et al. (1978). The EC model is not usually
derived from the micro foundations of optimizing behaviour, but is proposed
as a robust empirical relationship between macro aggregates that is
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