Individual income, incomplete information, and aggregate consumption

Abstract

Individual income is much more variable than aggregate per capita income. I argue that aggregate information is therefore not very important for individual consumption decisions and study models of life-cycle consumption in which individuals react optimally to their own income process but have incomplete or no information on economy-wide variables. 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 correlated with lagged income. On the other hand, the model has the same prediction for micro data as the standard permanent income model. The second part of the paper provides empirical evidence on individual and aggregate income processes. Different models for individual income are fit to quarterly data from the Survey of Income and Program Participation making various adjustments for measurement error. Calibrating the consumption model using the estimated parameters for the income process yields predictions which qualitatively correspond to the empirical findings for aggregate consumption but do not match them well in magnitude