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The Excess Smoothness of Consumption: Identification and Interpretation

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  • Marjorie A. Flavin

Abstract

The paper investigates the implications of the omitted information problem -- that is, the econometric problem which arises because an econometrician cannot explicitly include the complete set of variables potentially used by agents -- in the context of the "excess smoothness" phenomenon posed by Deaton 11987]. The paper shows that an econometrician who fails to take into account the effects of omitted information will incorrectly conclude that an empirical finding of excess smoothness of consumption implies that the income process is nonstationary. By contrast, with a more thorough understanding of the omitted information problem, the finding of excess smoothness of consumption is easily explained with two assumptions: a) the consumption data is generated by the excess sensitivity alternative hypothesis, in which consumption is a weighted average of current income and permanent income, and b) agents are forecasting on the basis of a larger information set than the econometrician. Further, excess smoothness is revealed to be consistent with a wide range of stationary income processes as well as nonstationary income processes. Thus the common presumption that the excess smoothness phenomenon is linked in an essential way to the stationarity or nonstationarity of the income process evaporates when omitted information is taken into consideration.

Suggested Citation

  • Marjorie A. Flavin, 1988. "The Excess Smoothness of Consumption: Identification and Interpretation," NBER Working Papers 2807, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2807
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    Cited by:

    1. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246, National Bureau of Economic Research, Inc.
    2. Tao Wang, 2023. "Perceived versus Calibrated Income Risks in Heterogeneous-Agent Consumption Models," Staff Working Papers 23-59, Bank of Canada.
    3. Stephen R. Blough, 1994. "Near common factors and confidence regions for present value models," Working Papers 94-3, Federal Reserve Bank of Boston.
    4. Li-gang Liu & Laurent Pauwels & Andrew Tsang, 2007. "Hong Kong's Consumption Function Revisited," Working Papers 0716, Hong Kong Monetary Authority.

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