Explaining Consumption - A Simple Test of Alternative Hypotheses

As might be expected from an activity that comprises well over half of aggregate economic spending, the behavior of private consumption remains one of the most important areas of economic research. As yet, however, there is little consensus on how to characterize the behavior of consumption empirically, with some investigators focusing on the importance of optimizing behavior in a world with complete markets and infinitely lived consumers and others on the impact of market imperfections, rules of thumb, and life-cycle effects. This paper combines elements of both literatures. Methodologically, a new specification for testing the relative importance of the path implied by risk sharing and by sensitivity to current income is derived. The specification is tested using data on consumption across Canadian provinces. The results indicate that both types of behavior are statistically significant. However, most of the marginal explanatory power comes from risk-sharing behavior rather than from changes in income, and the inclusion of terms that capture the behavior of fully insured consumers reduces the estimated proportion of consumption associated with changes in income. These results may help explain why the empirical characterization of consumption has been difficult to resolve. They imply that, while changes to income are a significant factor in explaining consumption, its importance may have been overstated in models that take no account of risk-sharing behavior. At the same time, the sensitivity to income is small enough to be difficult to identify in microeconomic data sets, where the data suffer from large amounts of noise. In summary, changes in income appear to be a significant, but relatively subsidiary, part of the explanation of variations in consumption, at least across Canadian provinces.