Excess Sensitivity of Consumption to Current Income: Liquidity Constraints or Myopia?

Abstract

Almost all of the recent empirical tests of the rational expectationspermanent income hypothesis (RE-PIH) have rejected the hypothesis. The null hypothesis in this empirical literature typically consists of the joint hypothesis that 1) agents' expectations are formed rationally, 2) desired consumption is determined by permanent income, and 3) capital markets are "perfect" in the sense that agents can lend or borrow against expected future income at the same interest rate. This paper attempts to determine whether the excess sensitivity of consumption to current income can be attributed to a failure of the third component of the joint hypothesis --the assumption of "perfect" capital markets --as opposed to a failure of one or both of the first two assumptions.