Consumption and Saving Behavior

Consumption and Saving Behavior To understand business cycle fluctuations, the effects of government deficits, long-run aggregate capital accumulation, and the determination of asset prices, we need to know how households allocate their income between consumption and saving. Much of my research focuses on the effects on consumer spending and saving of imperfections in the consumer credit market that constrain the amount of household borrowing, uncertainty in household income, and changes in the value of the stock market. The Importance of Borrowing Constraints The permanent-income theory of consumption says that the response of consumption to temporary changes in income should be small: households will save the bulk of positive windfalls to income and will run down their assets or borrow to keep consumption smooth in the face of drops in income. This view assumes that households have access to markets in which they can borrow against their future labor income. Yet aggregate U.S. consumption fluctuates more than the permanent-income hypothesis predicts. Credit markets are imperfect because banks do not have all possible information about loan applicants and cannot enforce loan repayments perfectly. Therefore, individuals who suffer a substantial drop in earnings cannot borrow large amounts of money with only their future labor earnings as collateral. I derive the theoretical implication of such borrowing constraints and test whether these limits on household borrowing have important effects on spending patterns.(1) To perform the tests, I use survey data from the Panel Study of Income Dynamics (PSID) on approximately 5000 households followed over 15 years. These data include a detailed breakdown of different types of income, tax information, and information on a component of consumer spending.(2) I split the sample into two groups: those families with few or no liquid assets in a given year, and those with higher liquid assets. I derive and test two implications of the model with borrowing constraints. First, once I take variations in aftertax interest rates into account, changes in consumption should be forecastable for the low-asset group but not for the high-asset group. The second implication begins with the observation that households that are unable to borrow still have the option of saving to smooth out high current income or low anticipated future income. Because of this, households with low current assets that are unable to borrow should have a higher expected growth of consumption than the rest of the population.(3) My results generally support the view that borrowing constraints affect the spending patterns of a significant fraction of the U.S. population. Consumption growth is both more predictable and, on average, higher for households that find themselves with few or no liquid assets in a given year. Precautionary Saving: The Effects of Income Uncertainty I also examine the effects on saving of uncertainty about future income--including the risk of becoming unemployed or disabled, or experiencing large increases or decreases in salaries.(4) Previous researchers had shown the conditions under which uncertainty raised the level of saving, but they were unable to determine the magnitude of the effect.(5) I demonstrate that uncertainty generally will raise the sensitivity of consumption to current income. I calculate what the consumption function would be, given empirical estimates of the magnitude of income uncertainty and plausible assumptions about consumers' preferences. Therefore, I am able to calculate the exact size of the effect of income uncertainty on both the level of consumption and the sensitivity of consumption to current income, Four important results have emerged from this line of research. 1. Precautionary saving is likely to be an important component of household saving. This is especially true for households whose lifetime resources consist primarily of uncertain future labor income. …