Consumption and Saving: Theory and Evidence

Consumption and saving decisions are at the heart of both short-run and long-run macroeconomic analysis (as well as much of microeconomics). In the short run, spending dynamics are of central importance for business cycle analysis and the management of monetary policy. And in the long run, aggregate saving determines the size of the aggregate capital stock, with consequences for wages, interest rates, and the standard of living. Since the pioneering work of Friedman and of Modigliani and Brumberg in the 1950s, the principal goal of the economic analysis of saving has been to formulate mathematically rigorous theories of behavior. But that goal was difficult until recently because the optimal response of saving to uncertainty was difficult to compute. Research was generally carried out under the assumption that uncertainty might boost saving somewhat, but that behavior in the presence of uncertainty was likely to be broadly similar to optimal behavior in a world in which households had perfect foresight about their future circumstances. In two papers that grew out of my 1990 dissertation, I showed that the presence of uncertainty could change the nature of optimal behavior in qualitatively and quantitatively important ways. Specifically, I examined the optimal behavior of consumers with standard attitudes toward risk (constant relative risk aversion), who faced income uncertainty of the kind that appears to exist in household-level data sources. The first paper found that target or “buffer-stock” saving can be optimal under some circumstances; the second paper found that, depending on households’ income profiles and their degree of impatience, it can be optimal for average household spending patterns to mirror average household income profiles over much of the life cycle. This was a surprising finding because in models without uncertainty optimizing consumers spend based on their expected lifetime resources without regard to the expected timing of income; that is, spending patterns by age are not intrinsically determined by income patterns by age. (This work, and my subsequent related work, assumes that consumers have successfully solved