Individual Income, Incomplete Information and Aggregate Consumption

Abstract

Individual income is much more variable than aggregate per capita income. I argue that aggregate information is therefore not very important for individual consumption decisions and construct a model of life-cycle consumption in which individuals react optimally to their own income process but ignore economy wide information. Since individual income is less persistent than aggregate income consumers will react too little to aggregate income variation. Aggregate consumption will be excessively smooth. Since aggregate information is slowly incorporated into consumption, aggregate consumption will be autocorrelated and correlated with lagged income. On the other hand, the model has the same prediction for micro data as the standard permanent income model. I argue that this is roughly in accord with the findings in the literature. The second part of the paper provides empirical evidence on individual and aggregate income processes and calibrates the model using the estimated parameters. The model predictions roughly correspond to the empirical findings for aggregate consumption. Allowing for the existence of measurement error in micro income, durables, finite lifetimes of consumers, and advance information improves the predictions of the model. These features introduce relatively small changes as compared to the impact of incomplete information.