Working Paper

Sticky information diffusion and the inertial behavior of durable consumption

Abstract: A leading theory of consumption behavior is that consumers choose their consumption based only on their expected total lifetime income. This theory is called the permanent income hypothesis. According to this theory, consumers should adjust their consumption if they experience a change that affects their expected lifetime income, such as through an unexpected change in employment that affects their expected earnings going forward. One challenge for this theory is that the empirical evidence on consumer spending decisions for durable and nondurable goods does not match the implications of this theory. In particular, this theory overpredicts the volatility of changes in both durable and nondurable goods and the correlation between them. ; This paper studies whether the standard permanent income model can better explain the behavior of durable and nondurable consumption if a more realistic assumption is used regarding the information that consumers possess when making decisions. The standard theory assumes that consumers observe all of the information that is relevant for decision making. Given that there is realistically a limit on the amount of information that an individual can acquire and use, this paper assumes that consumers can only observe part of the information that they need at the time of their consumption decision. One rationale for this assumption is that ordinary consumers simply cannot pay attention to all of the information in the real world (this idea is called rational inattention, proposed by Christopher Sims, Nobel Laureate in economics in 2011). This paper shows that introducing this partial information assumption improves the permanent income model by generating realistic dynamics of durable and nondurable consumption.

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2012

Number: RWP 12-11