Lecture Notes 1

Consumption under Uncertainty

Peter Fredriksson
30 November, 2004

1 Introduction
Q: Why bother explicitly about consumption?

A1 Consumption today determines well-being today but also well-

being ”tomorrow”; saving –i.e. deferred consumption –is central
to the standards of living in the long run.
A2 Consumption is the main component of the demand for goods,
so understanding ‡uctuations in consumption is necessary to un-
derstand the ‡uctuations in output. Private consumption as a
fraction of GDP is close to 50 percent in Sweden.
A3 Much of the innovations in empirical macro has come out of the
study of consumption.

Q: Are households rational life-cycle/permanent-income maximizers?

1.1 Some initial words of advice

Romer is a good intuitive reading, but at some points one could ask for more
in terms of formalism. My presentation will be slightly more formal. Remem-
ber, though, that most results can be derived from a two-period problem.

2 A digression:
2.1 A prototype problem
Suppose that the sequence of interest rates and labor income (Yt ) is known.
Abstract from labor supply decisions and assume further that consumers have

1
in…nite horizons. The problem for the consumer is to choose a consumption
sequence fCt+j g1
j=0 that maximizes discounted utility, i.e.

X
1
j
u(Ct+j ); 2 (0; 1) (1)
j=0

s.t.
At+1 = Rt+1 (At + Yt Ct ) (2)
At+j
lim Qj =0 (3)
s=0 Rt+s
j!1

where = 1+1 is the discount factor ( is the rate of time preference);

Rt+1 = 1 + rt+1 is the gross rate of return on …nancial assets, At .
The utility function u( ) is an increasing concave function with the usual
properties. At is an endogenous state variable that is predetermined at time
t; its evolution over time is given by the dynamic budget constraint – the
transition equation (2). The consumer in‡uences the evolution of At by
setting the control variable, Ct .
Equation (3) is the familiar No-Ponzi-Game condition (tranversality con-
dition). Without it the solution to the above problem is trivial. It is for the
consumer to borrow an in…nite amount such that the marginal utility of con-
sumption is minimized (since capital markets are assumed to be perfect there
are in principle no restrictions against that). However, the No-Ponzi-Game
condition rules that solution out.1
Let us derive the present value budget constraint. Rewrite (2) slightly

At+1
At = Ct Yt +
Rt+1
Substitute for At+1

1 At+2 X (Ct+j Yt+j )

1
At+2
At = Ct Yt + (Ct+1 Yt+1 + )= Qj + Q1
Rt+1 Rt+2 j=0 s=0 Rt+s s=0 Rt+s+1

where I’ve adopted the notational convention that Rt = 1. After T substitu-

tions we have
XT
(Ct+j Yt+j ) AT +t+1
At = Qj + QT
j=0 s=0 Rt+s s=0 Rt+s+1

1
In the strict sense, the no-Ponzi game condition should be formulated as
limj!1 At+j =( js=0 Rt+s ) 0. Why can we ignore the inequality?

2
Rearranging and letting T ! 1 we get
X
1
Ct+j X 1
Yt+j AT +t+1
Qj = At + Qj lim QT
s=0 Rt+s s=0 Rt+s s=0 Rt+s+1
T !1
j=0 j=0

Imposing the No-Ponzi-Game condition and de…ning

X
1
Yt+j
Ht = Qj
j=0 s=0 Rt+s

yields
X
1
Ct+j
Qj = At + H t (4)
j=0 s=0 Rt+s

This intertemporal budget constraint says that the present value of consump-
tion must equal the sum of …nancial (At ) and ”human”wealth (Ht ), the latter
being the present value of labor income.

2.2 Solving the problem: Dynamic programming

There are two ways of solving the problem: (i) either by ”direct attack”, i.e.
associate a Lagrange multiplier with (4) and calculate the optimal sequence
of consumption and asset holdings; (ii) dynamic programming.
The beauty of dynamic programming is that it collapses the in…nite hori-
zon problem into a sequence of two-period problems. The model is solved
recursively working backwards in time. The real power of dynamic program-
ming comes in problems that are more complex than the present one, for
instance problems involving uncertainty.
For the purpose of using dynamic programming, let us introduce the value
function, V (At ). The value function is completely analogous to the indirect
utility function in the static problem; it gives the value of the objective
function evaluated at the optimum. The value function will depend on initial
wealth, At ; just as the indirect utility function depends on income. Thus
" #
X1 X
1
j j
V (At ) = max u(Ct+j ) = max u(Ct ) + u(Ct+j+1 )
j=0 j=0
= max [u(Ct ) + V (At+1 )]
Ct ;At+1

s.t. the dynamic budget constraint

At+1 = Rt+1 (At + Yt Ct )

3
where At is given.
It is convenient to transform the problem by substituting the constraint
into the objective function. In this case, we eliminate Ct from the objective:
V (At ) = max [u(At + Yt At+1 =Rt+1 ) + V (At+1 )] (5)
At+1

Equation (5) is known as a functional equation or Bellman’s equation.2 As-

suming that V ( ) is di¤erentiable, the FOC is
u0 (Ct ) + Rt+1 V 0 (At+1 ) = 0 (6)
The …rst term of the LHS is the utility cost of saving, i.e. the utility cost
of transferring one unit of consumption to the future. Rt+1 is the return
on saving while V 0 (At+1 ) is the discounted shadow value of wealth – the
marginal gain in utility from an additional unit of …nancial wealth.
We wish to rewrite the FOC slightly by …nding an expression for V 0 (At+1 ).
The Envelope condition enables us to do that. Consider the e¤ects on the
RHS and LHS of (5) of a small change in At given the fact that At+1 is
optimally chosen
@V @V @At+1
V 0 (At ) = +
@A @A @A
|{z}t | t+1{z t }
direct e¤ect indirect e¤ect
@V
But At+1 is optimal so = 0. Only the direct e¤ect matters. Looking
@At+1
back on equation (5) we see that the direct e¤ect of changing At is the
marginal utility of consumption. Therefore V 0 (At ) = u0 (Ct ): the shadow
value of wealth equals the marginal utility of consumption along the optimal
path. If we shift this condition forward one period we have V 0 (At+1 ) =
u0 (Ct+1 ): Substituting this into (6) and rewriting we get
u0 (Ct ) = Rt+1 u0 (Ct+1 ) (7)
Equation (7) is the consumption Euler equation. Given a speci…cation of
preferences, the intertemporal budget constraint, and the Euler equation we
can in principle solve for the consumption function. Any solution will have
two properties (i) if capital markets are perfect, consumption depends on
wealth rather than current income; (ii) there will be consumption smoothing.
Since utility is concave the individual is better o¤ with a consumption path
that is smoother than the income path.
2
This equation is called a functional equation since the unknown function appears
on both sides of the equality. To prove that the value function exists one has to prove
that the value function has a unique …xed point to which it converges. If the underlying
utility function is continuous and strictly concave, then the value function will inherit this
property implying that it is di¤erentiable.

4
2.2.1 Example: Rate of time preference equal to rate of interest
Suppose Rt = R = 1= . Then by (7) Ct = Ct+1 . Using this and Rt = R in
(4) we get
X1
1
Ct = At + H t
j=0
Rj
P
Since 1 1 1+r
j=0 Rj = r we have

r
Ct = (At + Ht )
1+r
Thus consumption in each period equals the yield on the individuals total
wealth. The yield on wealth is referred to as permanent income; Friedman
(1957).

2.2.2 Example: Isoelastic preferences/CRRA preferences

Suppose that preferences are given by

Ct1 1
u(Ct ) = ; 6= 1
1
= ln Ct ; =1

The coe¢ cient does double duty. Firstly, it re‡ects the curvature of the
utility function; in particular we have that the coe¢ cient of relative risk
aversion is
u00 (Ct )
Ct =
u0 (Ct )
Secondly, as you may remember, the intertemporal elasticity of substitution,
, is given by = 1= . The intertemporal elasticity of substitution measures
consumers’willingness to substitute consumption between di¤erent points in
time.
The Euler equation is

Ct = Rt+1 Ct+1

Rearranging slightly we get

Ct+1
= (Rt+1 )1=
Ct
Taking logs and using the de…nition of we have

ln Ct+1 = ln Rt+1 + ln ' (rt+1 ) (8)

5
where we have used the approximation ln(1 + x) ' x, which is valid for small
x. Equation (8) relates the percent change in consumption to the deviation
between the interest rate and the rate of time preference. If rt+1 increases
the growth rate of consumption increases. As the price of consuming today
(rt+1 ) increases, consumption is shifted towards the future. The magnitude
of the response of savings to changes in the interest rate is given by the
parameter . For utility functions that are extremely concave is high and
consequently is low; then there is a small response of the growth rate of
consumption to variations in the interest rate.
Notice that the Euler equation, in this case (8), says nothing about how
the level of consumption responds to the interest rate. It only indicates how
the change in consumption relates to the interest rate.
Exercise: Take a two-period model and a CRRA utility function. Derive
the consumption function. When does consumption increase/decrease in
response to an increase in the interest rate? Explain.

3 Consumption under uncertainty

3.1 The problem
Continue to assume that the sequence of interest rates is known. Now, how-
ever, labor income (Yt ) is stochastic. The problem for the consumer is then
to choose a consumption sequence fCt+j g1 j=0 that maximizes expected dis-
counted utility, i.e.
(1 )
X
j
Et u(Ct+j ) ; 2 (0; 1) (9)
j=0

s.t.
At+1 = Rt+1 (At + Yt Ct ) (10)
At+j
lim Et Qj =0
s=1 Rt+s
j!1

Here Et denotes the expectation conditional on the information available in

time period t (It ). Suppose that labor income is a stationary (j j < 1) …rst
order auto-regressive process:
Yt+1 = k + Yt + t (11)
then the information set in t includes Yt only. If some other (i.i.d.) variable,
Zt ; is known to a¤ect income then the relevant information set would include
Zt as well. In this setting, Yt is an exogenous state variable.

6
 As before the constraints de…ne an intertemporal budget constraint, but
this time it has to hold in expectation.
X
1
Ct+j X 1
Yt+j
Et Qj = At + Et Qj = At + Et (Ht ) (12)
j=0 s=0 Rt+s j=0 s=0 Rt+s

To solve the problem we use dynamic programming. The basic structure

of the value function is the same as before, but now we condition the value
function on the two state variables At and Yt :

V (At ; Yt ) = maxfu(At + Yt At+1 =Rt+1 ) + Et [V (At+1 ; Yt+1 )]g

At+1

Assuming that V ( ) is di¤erentiable we have the FOC

u0 (Ct ) + Rt+1 Et [VA (At+1 ; Yt+1 )] = 0

where VA denotes the partial derivative w.r.t. At+1 . As before, there is an En-
velope property such that VA (At ; Yt ) = u0 (Ct ). Shifting this equation one pe-
riod forward and taking conditional expectations we have Et [VA (At+1 ; Yt+1 )] =
Et [u0 (Ct+1 )]. Inserting this into the FOC we have the stochastic version of
the consumption Euler equation

u0 (Ct ) = Rt+1 Et [u0 (Ct+1 )] (13)

Notice that the solution to the stochastic dynamic optimization problem

speci…es a contingent plan, i.e. a course of action for every possible realization
of the uncertain income process. (In the problem with no uncertainty the
solution is a unique plan)

3.2 Quadratic utility and certainty equivalence

In most cases we cannot solve the dynamic optimization problem explicitly.
But in one special case we can actually obtain the analytical solution.3 This
is when the problem is ”linear-quadratic”, i.e., when the objective function
is quadratic and the transition equation is linear. Such preferences, however,
have an unattractive property: they imply certainty equivalence; the behavior
is the same as when mean income is known with certainty.
To see where this property comes from, notice that in general Et [u0 (Ct+1 )] 6=
0
u [Et (Ct+1 )], since the marginal utility of consumption is a non-linear func-
tion. But if the marginal utility of consumption is linear, which it is if utility
3
There is one additional special case where we can solve the model analytically. This
is with a CARA utility function and …nite horizon; see exercise 2.

7
is quadratic, Et [u0 (Ct+1 )] = u0 [Et (Ct+1 )]. Therefore, the degree of uncer-
tainty in the consumption process does not in‡uence the marginal utility of
consumption, only expected consumption matters for marginal utility.
Let us solve the problem. Assume that instantaneous utility is given by
a 2
u(Ct ) = bCt C
2 t
Then u0 (Ct ) = b aCt . Assume for convenience that Rt+1 = 1. The Euler
equation then simpli…es to
Et (Ct+1 ) = Ct (14)
Thus, expected consumption in the next period is equal to current consump-
tion. Let us solve for the consumption function. Notice that (14) implies
Et (Ct+j ) = Ct . Insert this into (12) and use Rt = R = 1 + r. We get
r
Ct = [At + Et (Ht )] (15)
1+r
which is identical to what we had with no uncertainty with the exception
that the expectation of human wealth (Et (Ht )) as of time period t enters the
consumption function rather human wealth (Ht ). Thus the variance of the
income process does not matter for consumption.
How does consumption respond to transitory changes in income? To an-
swer this question take the expectations of (15) as of period t 1
r
Et 1 (Ct ) = [Et 1 (At ) + Et 1 (Ht )]
1+r
Use Et 1 (Ct ) = Ct 1 according to (14) and Et 1 (At ) = At by the transition
equation (10):
r
Ct 1 = [At + Et 1 (Ht )]
1+r
So
r
Ct Ct 1 =
[Et (Ht ) Et 1 (Ht )]
1+r
Thus the change in consumption is equal to the revision of expectations of
future labor income. Now suppose, again, that labor income is a stationary
…rst order stochastic process:
Yt+j = k + Yt+j 1 + t+j

By repeated substitutions, the RHS can be written as

j 1 j 1
X X
i j i
Yt+j = k + Yt + t+j i (16)
i=0 i=0

8
Since
X
1
Et (Yt+j ) Et 1 (Yt+j )
Et (Ht ) Et 1 (Ht ) =
j=0
(1 + r)j

we want to calculate the di¤erence between the expectations of (16) given

period t and t 1 information. This di¤erence equals
j j
Et (Yt+j ) Et 1 (Yt+j ) = [Yt Et 1 (Yt )] = t

Therefore
X
1 j
1+r
Et (Ht ) Et 1 (Ht ) = t = t
j=0
1+r 1+r

and, …nally,
r r
Ct Ct 1 = [Et (Ht ) Et 1 (Ht )] = t
1+r 1+r
Thus the change in consumption in response to an unexpected change in
income is less than unity if the income process is stationary ( < 1). Con-
sumption smooths transitory changes in income. If the income process has
a unit root ( = 1) then the response equals unity. Notice also that the
marginal propensity to consume out of transitory changes in income is not a
policy invariant parameter. Since the MPC is a function of , and , in turn,
is in‡uenced by policy, estimates of the MPC cannot be used for analyzing
policy experiments; cf. the Lucas critique.
Question: What is the marginal propensity to consume out of permanent
income?
The assumption of quadratic utility is unattractive for a couple of reasons:
(i) uncertainty does not matter for consumption behavior; (ii) it implies
increasing absolute risk aversion.

3.3 Consumption empirics

Consumption empirics was revolutionized in the late 1970’s by a paper by
Hall (1978). Hall’s important insight was that in order to test the life-
cycle/permanent income hypothesis it is not necessary to estimate the con-
sumption function. Rather, one can test theory by estimating the Euler
equation. Consider the Euler equation with quadratic utility and a constant
interest rate.
1+r
b aCt = Et (b aCt+1 )
1+

9
A simple rewriting of this equation yields

(r )b 1 +
Et (Ct+1 ) = + Ct
(1 + r)a 1 + r

which implies a regression equation on the form

Ct+1 = 0 + 1 Ct + "t+1

where Et ("t+1 j It ) = 0 because of rational expectations. Thus, theory im-

plies that no other variable than lagged consumption should help predict
consumption in the current period. This is so since this information is al-
ready incorporated in the choice of Ct . If = r, then consumption follows a
random walk (More generally, the marginal utility of consumption is a ran-
dom walk if utility is not quadratic.) Notice also that the parameters of the
Euler equation are policy invariant.
Hall tested theory by running a regression of the following form

Ct+1 = 0 + 1 Ct + 2 Zt + "t+1

where Zt denotes a vector of variables known at t. If theory is correct then

^ 2 should not be signi…cantly di¤erent from 0. Hall came to the conclusion
that 2 = 0 could not be rejected (if Zt included further lags of consumption
or lagged income).
Later work has often come to a di¤erent conclusion than Hall. One par-
ticular example is Campbell and Mankiw (1989). They tested PIH against a
speci…c alternative. In particular, expected changes in income should not in-
‡uence the change in consumption. Campbell and Mankiw considered a world
consisting of two types of households. A fraction of the households behave
according to a ”rule of thumb” (alternatively are liquidity constrained) and
simply consume their income, while a fraction (1 ) behave according to
the PIH. If this is the case, then (given = r) we have

Ct+1 = Yt+1 + (1 )"t+1 = Yt+1 + vt+1 (17)

They estimated this equation using aggregate time series data. A problem is
that Yt+1 and vt+1 are most likely correlated. During times when income
increases ( Yt+1 > 0) individuals are more likely to get favorable news about
their permanent income ("t+1 > 0). Thus, OLS estimates of this equation
will yield biased results –an instrumental variables (IV) approach is needed.
Valid instruments should not be correlated with "t+1 (this is a delicate task).
The solution is to run a …rst stage prediction equation where the instruments

10
are used to predict Yt+1 . The …rst stage regression might have the following
appearance

Yt+1 = 0 + 1 Yt + 2 Ct + 3 Ct 1 + t+1

Use the estimates to construct d Y t+1 and then run the (second stage) re-
gression
Ct+1 = d Y t+1 + v~t+1
and then test the hypothesis = 0.4 The results in Campbell and Mankiw
indicate that ^ 0:4 0:5. Thus predicted income growth a¤ects consump-
tion growth; there is excess sensitivity of consumption. Excess sensitivity is
sometimes attributed to liquidity constraints.
Should one be surprised that the model fails given that we are trying to
estimate an individual behavioral equation using aggregate data? We return
to this question later.

3.4 Interest rates and consumption

Let us revert back to the CRRA utility function.

Ct1 1
u(Ct ) = ; 6= 1
1
= ln Ct ; =1

The Euler equation with a stochastic interest rate is given by

Ct = Et (Rt+1 Ct+1 )

Rewriting slightly we have:

1 = Et (Rt+1 Gt+1 )

where G (Ct+1 =Ct ) is the (gross) growth rate of consumption. Now, sup-
pose that ln(RG ) is normally distributed. This is useful since we know
that if x N ( ; v 2 ) then E[exp(x)] = exp( ) exp(v 2 =2); see Romer exercise
7.3. We can use this information to develop the expectations term in the
equation above into something emprically useful. Since

RG = exp(ln R ln G)
4
If the IV procedure is literally done in two stages then the standard errors must be
corrected.

11
and
2
var(ln R ln G) = var(ln R) + var(ln G) 2 cov(ln G; ln R)
| {z } | {z } | {z }
=vr2 =vg2 =vrg

we have

E(RG ) = E[exp(ln R ln G)]

2 2
vr2 + vg 2 vrg
= exp[E(ln R) E(ln G)] exp[ ]
2
Insert this into the Euler equation, take logs and reshu- e. We get
2 2
1 vr2 + vg 2 vrg 1
Et (ln Gt+1 ) = [ + ln ] + E(ln Rt+1 )
2
By rational expectations, this implies a regression equation of the form

ln Ct+1 = 0 + rt+1 + ~"t+1 (18)

where 1= and Et (~"t+1 ) = 0.

By estimating (18) one can estimate the intertemporal elasticity of substi-
tution, . The results in Hall (1988) suggests that ^ 0:1. Thus consump-
tion growth does not respond much to changes in the interest rate. What
does this imply for the coe¢ cient of risk aversion?

3.5 Prudence/Precautionary saving

As noted earlier, quadratic utility has some implausible implications. In par-
ticular, individuals have increasing absolute risk aversion. That is, they are
willing to give up more consumption to avoid a given amount of uncertainty
as they become wealthier. A plausible attitude towards risk implies that
absolute risk aversion declines as wealth increases. Absolute risk aversion is
de…ned by
u00 (C)
a(C) = >0
u0 (C)
so
u0 (C)u000 (C) [u00 (C)]2
a0 (C) =
[u0 (C)]2
For this to be negative, u000 (C) must be positive. Utility functions having
a positive third order derivative is said to re‡ect prudent behavior. (Note
quadratic utility functions have u000 (C) = 0, so a0 (C) > 0).

12
 Let us return to the simple case where Rt+1 = 1. The Euler equation is

Et [u0 (Ct+1 )] = u0 (Ct )

Let us make a second order Taylor approximation of u0 (Ct+1 ) and evaluate

at Ct . This yields

0 0 00 u000 (Ct )
u (Ct+1 ) u (Ct ) + u (Ct )(Ct+1 Ct ) + (Ct+1 Ct )2
2
Take expectations and insert into the Euler equation. We get

u000 (Ct ) Et (Ct+1 Ct )2

Et (Ct+1 Ct ) =
u00 (Ct ) 2

Transforming this equation slightly and using the log approximation (ln Ct+1
ln Ct (Ct+1 Ct )=Ct )

u000 (Ct )Ct Et (ln Ct+1 ln Ct )2

Et (ln Ct+1 ln Ct ) =
u00 (Ct ) 2

Finally, Et (ln Ct+1 ln Ct )2 vart (ln C), so

u000 (Ct )Ct vart (ln C)

Et (ln Ct+1 ln Ct ) = (19)
u00 (Ct ) 2

If u000 > 0, the expected growth rate of consumption (LHS) is positive, i.e.
there is precautionary savings. An increase in uncertainty –an increase in the
variance of consumption – implies greater precautionary savings and hence
greater expected consumption growth.
The term ( u000 C=u00 ) in (19) is referred to by Kimball (1990) as the
coe¢ cient of relative prudence. As the coe¢ cient of relative risk aversion
measures the curvature (concavity) of the utility function, the coe¢ cient of
relative prudence measures the curvature (convexity) of the marginal utility
function. The greater the coe¢ cient of relative prudence, the stronger is
the precautionary savings motive. With the CRRA utility function, the
coe¢ cient of relative prudence equals ( + 1); see Romer p. 356.
Illustration...(Romer, p. 356)

3.6 Liquidity constraints

Consider a situation where there are borrowing constraints such that At+1
0. This means that Ct (Yt + At ). Associate a Kuhn-Tucker multiplier

13
( t ) with this constraint and suppose that Rt+1 = = 1 for simplicity. The
modi…ed Euler equation is

u0 (Ct ) = Et [u0 (Ct+1 )] + t

If the constraint is binding, then t > 0; if it is not binding t = 0. It is easy

to see that if the constraint binds, then the marginal utility of consumption
would have to be greater than in the unconstrained optimum (since t > 0).
Thus consumption is lower if the constraint binds.
The more subtle point is that consumption in the current period will be
a¤ected by the presence of borrowing constraints even if the standard Euler
equation
u0 (Ct ) = Et [u0 (Ct+1 )]
holds in the current period. To see this point more clearly consider the Euler
equation for the next period

u0 (Ct+1 ) = Et+1 [u0 (Ct+2 )] + t+1

Take the expectation given the information in period t

Et [u0 (Ct+1 )] = Et [u0 (Ct+2 )] + Et ( t+1 )

where we have used the law of iterated expectations. Substitute this back
into the standard Euler equation

u0 (Ct ) = Et [u0 (Ct+2 )] + Et ( t+1 )

Thus, if there is a probability that the constraint will bind in the future,
Et ( t+1 ) > 0, consumption in the present period will be lower than it would
have been without liquidity constraints, even though the standard Euler equa-
tion holds. Thus, simply appending predicted income growth to an otherwise
standard Euler equation is likely to be a poor tool to identify the presence
of liquidity constraints.

4 Conclusion: The state of the PIH

The permanent income hypothesis applies to individual behavior. Thus,
testing the hypothesis using aggregate time series data is probably less than
fruitful. Suppose that we take CRRA utility seriously. Then it is clear that
the log of average consumption is not the same thing as the average of log
consumption. Thus serious tests of the hypothesis require micro (panel) data.
This point is made forcefully by Attanasio (1999).

14
 In an interesting application, Shea (1995) uses household data to exam-
ine the excess sensitivity of consumption. Based on these data he analyzed
households that were covered by long-term union contracts, i.e. households
that had a pretty good idea about their future earnings. On the basis of the
contract he predicted earnings and regressed consumption growth on pre-
dicted wage growth (and controls). The estimated coe¢ cient on predicted
wage growth is 0.89 and marginally signi…cant and so the life-cycle model is
rejected.
Attanasio (1999), on the other hand, argues that many of the rejections
of the life-cycle model is driven by a failure to take proper account of demo-
graphics and the assumption that consumption and leisure are separable in
the utility function (which we have assumed throughout). If proper account
is taken of these complications then there is no evidence of excess sensitivity
of consumption; furthermore, the estimate of the intertemporal elasticity of
substitution (the coe¢ cient on the interest rate) is just below one.
In sum, the verdict is still out. The interesting question is perhaps how
good an approximation the life-cycle model is of reality. Moreover, the empir-
ical Euler equations literature (although rigorous) is not providing the answer
we want. The Euler equation for consumption is not a consumption function
and cannot answer, e.g., the question about how the level of consumption
responds to policy changes.

References
Attanasio, O.P. (1999), Consumption, in J.B. Taylor and M. Woodford
(eds.) Handbook of Macroeconomics vol 1B, Elsevier Science, 741-812.

Campbell, J.Y. and N.G Mankiw (1989),Consumption, Income, and Interest

Rates: Reinterpreting the Time Series Evidence, in O.J. Blanchard and
S. Fischer (eds.) NBER macroeconomics annual, MIT Press, 185-216.

Friedman, M. (1957), A Theory of the Consumption Function, Princeton

University Press.

Hall, R.E. (1978), Stochastic Implications of the Life Cycle-Permanent In-

come Hypothesis: Theory and Evidence, Journal of Political Economy
86, 971-87.

Hall R.E. (1988), Intertemporal Substitution in Consumption, Journal of

Political Economy 96, 339-57.

15
Kimball, M.S. (1990), Precautionary Saving in the Small and in the Large,
Econometrica 58, 53-73.

16