Consumption Over the Life Cycle: A Distributional Study of Theory vs. Evidence. ROW Planning Grant

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Many researchers have found that the life cycle/permanent income theory of consumption fails to explain movements of aggregate consumption and savings. What does determine savings remains unclear, especially given that the motives behind savings are not the same for all individuals. In particular, such motives are likely to differ significantly across groups of individuals with different levels of lifetime incomes and/or different profiles of lifetime incomes. In this project, a data set is developed on lifetime incomes and consumption paths using data from the Panel Study on Income Dynamics and the Consumer Expenditure Survey. The lifetime data will then be used to ascertain to what extent the life cycle theory explains observed patterns for different types of consumers. For each consumer category, observed patterns of total consumption will be compared with those predicted by the life- cycle theory and those predicted by alternative explanations. These alternatives include "rules of thumb", the "behavioral" life-cycle hypothesis, the presence of liquidity constraints, and myopia. The final stage of the research is to go beyond casual empiricism and develop more appropriate econometric tests for the alternative explanations. Consumption function and Euler equation approaches will be among those considered; however, more powerful tests may be possible given the wealth of information that will be available in the lifetime data set. The result of this research will be a better understanding of what determines savings.