Individual Income, Incomplete Information and Aggregate Consumption

In this paper I study a model of life-cycle consumption in which individuals react optimally to their own income process but ignore economy wide information. Since individual income is less persistent than aggregate income consumers will react too little to aggregate income variation. Aggregate consumption will be excessively smooth. Since aggregate information is slowly incorporated into consumption, aggregate consumption will be autocorrelated and cOITelated with lagged income. The second part of the paper provides empirical evidence on individual and aggregate income processes and calibrates the model using the estimated parameters. The model pr~Jictions roughly correspond to the empirical findings for aggregate consumption data. Allowing for the existence ofmeasurement error in micro income, durables, finite lifetimes ofconsumers, and advance information improvesthe predictions ofthe model.

Pischke, Jörn-Steffen (1991), Individual Income, Incomplete Information and Aggregate Consumption, ZEW Discussion Paper No. 91-07, Mannheim.