Consumption Income Dynamics Under Rational Expectation: Theory and Evidence

In this paper we formulate and estimate an intertemporal model of the relationship between consumers’ expenditure and disposable income for Greece. We use annual time series for the period 1953-1978. Our explanation of the dynamics that characterize the consumption function rests on the existence of convex costs of adjustment that do not allow consumers to reach their desired level of consumption immediately after a change in their disposable income. The consumption function we get from the formal statement of this problem is dynamically well specified and does not ignore expectations, as the rational expectations hypothesis is imposed. Our estimates suggest a short run income elasticity of consumption of around 0.4 and are not inconsistent with a unitary long run elasticity. The costs of deviating from the long run consumption income ratio, relative to the costs of adjusting consumption are in the range of 0.005 to 0.014, suggesting that adjustment costs are 200 to 71.4 times higher than the costs of deviating from long run equilibrium. This suggests that habit persistence is very strong. Our estimates of the discount factor suggest a rate of time preference of the order of 5.7% to 2.5% per annum.

(with J. Nissim), Greek Economic Review

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