Consumption volatility and income persistence in the permanent income model

Abstract

Deaton's “excess smoothness” question can be reformulated by focusing attention on total income rather than labour income: the permanent income theory predicts that the relative volatility of consumption is equal to total income persistence, a fact that is contradicted by empirical evidence. This formulation is more general than the original one in that it is independent of the value of the interest rate, the univariate dynamics of labour income and the information set of the representative consumer. When properly formulated, the excess smoothness problem cannot be solved within Quah's superior information model; as a consequence, the interest of alternative solutions such as aggregation models is increased.