Do Consumption and Income Have a Long Run Relationship?

Jae-Young Kim

Associate Professor, School of Economics, Seoul National University, San 56-1 Shilim-dong, Kwanak-gu, Seoul 151-742, Korea jykim017 @snu.ac.kr

JEL Classification: C12, C52

Abstract

This paper provides some new empirical evidence on the consumption-income relation which is one of the most thoroughly studied subjects in economics. According to the recent literature in economics the two variables should be cointegrated for many theoretical results in economics, such as the permanent income hypothesis, to be meaningful. Our initial empirical results, however, show that cointegration between income and consumption is not well confirmed for U.S. quarterly data for extended postwar periods. This is an important problem that has to be addressed in the literature. In this paper we conjecture that failure of confirming cointegration for the consumption-income relation is due to nonstationary fluctuations in some relatively short period(s) although the relation prevails in the majority of data period. Our empirical result confirms our conjecture. Two periods of “short-run” nonstationarity are identified for an extended postwar era of the U.S. economy: One is the Volker era in the early 1980's and the other consists of the recent years of unusually low interest rate. Our result has important implication for empirical analysis in economics where consumption and income variables are involved.

Keywords:

Consumption-income relation, Cointegration, Short-run nonstationarity, Partial sample cointegration breakdown

Acknowledgments

I thank anonymous referees for helpful comments. I also thank Don Andrews, Michael Jerison, and Terry Kinal for helpful comments, and Woong-Yong Park for research assistance. I gratefully acknowledge the financial supports from the Advanced Strategy Program (ASP) of the Institute of Economic Research, Seoul National University, and BK21 program of Korea Research Foundation.

References

Andrews, D. W., and Kim, J.-Y. End-of-Sample Cointegration Breakdown Test. Cowles Foundation Discussion Paper No. 1404, Yale University. Available at http://cowles.econ.yale.edu, , 2003.
Campbell, J. Y. “Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis.” Econometrica 55 (No. 6 1987): 1249-73. [https://doi.org/10.2307/1913556]
Davidson, J. E. H., Hendry, D. F., and Yeo, S. “Econometic Modelling of the Aggregate Time-Series Relationship between Consumer's Expenditure and Income in the United Kingdom.” Economic Journal 88 (No. 352 1978): 661-92. [https://doi.org/10.2307/2231972]
Flavin, M. A. “The Adjustment of Consumption to Changing Expectations about Future Income.” Journal of Political Economy 89 (No. 5 1981): 974-1009. [https://doi.org/10.1086/261016]
Hall, R. E. “Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence.” Journal of Political Economy 86 (No. 6 1978): 971-87. [https://doi.org/10.1086/260724]
Keynes, J. M. The General Theory of Employment, Interest and Money. London: Macmillan and Co., 1936.
Kim, J.-Y. “Inference on Segmented Cointegration.” Econometric Theory 19 (No. 4 2003): 620-39. [https://doi.org/10.1017/S0266466603194078]
Phillips, P. C. B., and Ouliaris, S. “Asymptotic Properties of Residual Based Tests for Cointegration.” Econometrica 58 (No. 1 1990): 165-93. [https://doi.org/10.2307/2938339]
Pollock, D. S. G., and Lekka, N. Deconstructing the Consumption Function: New Tools and Old Problems. Mimeograph, Queen Mary: University of London, 2004.