Precautionary Saving and Consumption Fluctuations∗

This paper uses the consumption Euler equation to derive a decomposition of consumption growth into four sources. These are new information and three sources of predictable consumption growth: intertemporal substitution, changes in the preferences for consumption, and incomplete markets for consumption insurance. Using data on the expenditures of households, we implement the decomposition for the average growth rate of consumption expenditures on nondurable goods in the U.S. from the beginning of 1982 to the end of 1997. Incomplete markets for trading consumption in future states lead to statistically signiÞcant and countercyclical movements in expected consumption growth: consumption growth is expected to be higher when the unemployment rate is high. The economic importance of precautionary saving rivals that of the real interest rate, but the relative importance of each source of movement in the volatility of consumption is not precisely measured. ∗For helpful comments, we thank David Card, Charles Fleischman, Pierre Olivier Gourinchas, Bo Honore, Andrew Samwick, John Shea, Chris Sims, Stephen Zeldes, two anonymous referees, and seminar participants at the Australian National University, University of Chicago Graduate School of Business, Dartmouth College, Princeton University, the Reserve Bank of Australia, the 2001 North American Winter Meeting of the Econometric Society, and the 2002 NBER Summer Institute. We thank Ben Bernanke and Ilan Mihov for providing us with their series of monetary policy shocks. For Þnancial suport, Parker thanks the National Science Foundation grant SES-0096076, the Sloan Foundation, and a National Bureau of Economic Research Aging and Health Economics Fellowship through National Institute on Aging grant number T32 AG00186 and Preston thanks the Fellowship of Woodrow Wilson Scholars.