Consumption Theory

Handbooks in Central Banking

No. 23

CONSUMPTION THEORY

Emilio Fernandez-Corugedo

Series editors: Andrew Blake & Gill Hammond
Issued by the Centre for Central Banking Studies,
Bank of England, London EC2R 8AH
E-mail: [e-mail]
July 2004
© Bank of England 2004
ISBN 1 85730 143 9

Consumption Theory
Emilio Fernandez-Corugedo1
Centre for Central Banking Studies, Bank of England

1

This Handbook represents the views and analysis of the author and should not be thought to represent those of the Bank of England or Monetary Policy Committee members. The Handbook is a modified chapter from my Bristol University PhD thesis ‘Essays on Consumption’. I would like to thank my PhD advisers
Cliff Attfield, Nigel Duck and David Demery for their insights. Suggestions from Andrew Benito, Andrew
Blake, Gill Hammond and Paul Robinson greatly improved the Handbook. All errors and omissions remain, of course, my responsibility.

Contents
1 Introduction

2

2 Consumption: key theories and terminology
2.1 The absolute income hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 The permanent income hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3 The life cycle hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2
2
3
5

Box A: Understanding consumption terminology

6

3 Rational expectations, unit roots and poor forecasting

9

4 The rational expectations permanent income hypothesis

10

Box B: The impact of interest rates on consumption

12

Box C: The role of assumptions in REPI

13

5 Departing from REPI
5.1 Breaking certainty equivalence: precautionary saving . . . . . . . .
5.1.1 The buffer stock model . . . . . . . . . . . . . . . . . . . .
5.2 Near rationality and aggregation . . . . . . . . . . . . . . . . . . .
5.2.1 Near rationality and the updating of consumption decisions
5.2.2 Near rationality and imperfect information . . . . . . . . .
5.3 Liquidity constraints . . . . . . . . . .

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