Rational expectations test and excess sensitivity test of consumption -PhD Thesis-
Benchmark models of optimization, in the spirit of the Rational Expectation Permanent Income Hypothesis, present a strong theoretical case for a smooth consumption regime in which households do not let consumption fluctuate with anticipated variations in explanatory variables. However, numerous studies in the past have empirically reflected the primary underpinning of the theory in aggregate level. This study attempts to provide substantial insight into the nature of household consumption dynamics over a life cycle with relation to subjective data derived from the British Household Panel Survey and examines the cause for the failure of the baseline story. These subjective data are used to test the rationality of consumer expectations and to assess their usefulness in forecasting expenditure. The results can also be interpreted as characterizing the shocks that have hit different types of households over time. Individuals’ expectations are found to be biased, at least ex post, in that forecast errors did not average out over a sample period lasting 12 years. Forecasts are also inefficient, in that people’s forecast errors are correlated with their demographic characteristics and/or aggregate shocks did not hit all people uniformly. Further, financial situation variables are found to be useful in forecasting future consumption, even controlling for demographic variables. This excess sensitivity is counter to the rational expectation permanent income hypothesis.
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