The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives
Abstract
Suppose a consumer sets consumption equal to income each period, rather than following the optimal permanent income decision rule. How much utility does he lose? This paper finds that the answer is typically less than 10 cents-$1 per quarter in environments specified by popular tests on aggregate data. It includes calculations of the costs of excess sensitivity and excess smoothness to income and interest rate changes and the costs of ignoring information. It concludes that the theory does not make predictions for aggregate tests that are robust to small costs, such as information or transactions.
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