Journal of Economic Literature 48 (September 2010): 693–751 http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.3.693 Consumption and Saving: Models of Intertemporal Allocation and Their Implications for Public Policy Orazio P. Attanasio and Guglielmo Weber* This paper provides a critical survey of the large literature on the life cycle model of consumption, both from an empirical and a theoretical point of view. It discusses several approaches that have been taken in the literature to bring the model to the data, their empirical successes, and their failures. Finally, the paper reviews a number of changes to the standard life cycle model that could help solve the remaining empirical puzzles. 1. Introduction perspective, it is difficult to construct coher- ent models based on intertemporal opti- n the early 1950s, the prevailing model mizing behavior that are consistent with Iof consumption behavior used by mac- Keynes’s description of the “fundamental roeconomists was inspired by the “funda- psychological law.” From an empirical point mental psychological law” mentioned by of view, it seemed that Keynes’s view was John Maynard Keynes (1936) in the General inconsistent with a number of facts, both at Theory. At that time, the theoretical and the macro and the micro level. At the aggre- empirical limitations of that model became gate level, for instance, it was observed that increasingly clear. From a theoretical the marginal propensity to consume out of disposable income was lower in the short run * Attanasio: UCL, IFS, NBER, and CEPR. Weber: than in the long run. In cross sections, on the Università di Padova, IFS, and CEPR. We are grateful other hand, saving rates seemed to change to a very large number of people for a number of differ- systematically with the level of income. ent reasons. Our thinking about the issues discussed in this paper has been particularly influenced by a set of people, Moreover, it was observed that groups of several of whom have been coauthors in several projects. individuals with, on average, lower levels They include: Rob Alessie, James Banks, Richard Blundell, of income (such as blacks) had higher sav- Martin Browning, Angus Deaton, Hamish Low, Tom MaC- urdy, Costas Meghir, and Luigi Pistaferri. We have discussed ing rates than other groups with higher lev- many of the issues covered in this paper (and sometimes dis- els of average income (such as whites) at agreed) with them. We certainly learned a lot from them. any income level. Finally, it was observed We are very grateful to three referees and Erik Hurst for useful comments and suggestions, and to the Editor for that saving rates are systematically related comments, suggestions, and incredible patience! Attanasio’s to changes in income, being higher for indi- research was partially financed by ESRC grant RES-051- viduals experiencing income increases and 27-0125. Weber’s research was partially financed by MIUR grant 2007AC54X5. Weber is also grateful to ESRI, Cabinet lower for individuals experiencing income Office, Tokyo, for hospitality and many useful discussions. decreases (see George Katona 1949). 693 694 Journal of Economic Literature, Vol. XLVIII (September 2010) All these observations clearly contra- After its initial development, the other dicted the implications of the Keynesian important step in the development of the model and led to the formulation of the life cycle/permanent income model, which life cycle and permanent income models is currently used as the standard workhorse (Franco Modigliani and Richard Brumberg of modern macroeconomics, was a rigorous 1954, 1980; Milton Friedman 1957). These treatment of uncertainty. In the late 1970s, models combined theoretical consistency the contributions of Robert E. Hall (1978) in that intertemporal consumption and sav- (and Thomas E. MaCurdy 1981, 1999 in the ing choices were set within a coherent opti- context of labor supply) exploited the idea of mization problem with the ability of fitting using the first-order conditions of the inter- most of the facts mentioned in the previous temporal optimization problem faced by the paragraph. The saving rates of blacks was consumer to derive testable implications (and is) higher than that of whites at any of the model. This approach, known as the income level because the permanent income Euler equation approach, makes possible of blacks is lower and, therefore, condition- the empirical analysis of a problem that is ing on a common income level, one selects analytically intractable by circumventing the the blacks with a higher level of temporary need to derive closed-form solutions. This shocks that should, according to the model, is achieved by focusing on the economic be saved. Similarly, individuals with income essence of the model: consumers, at the opti- increases are more likely to be affected by mum, will act to keep the marginal utility of positive transitory shocks. At the macro level, wealth constant over time. The marginal util- short-run fluctuations in disposable income ity of wealth is at the same time a sufficient are more likely to be dominated by the vari- statistic for consumer choices and, given its ance of temporary shocks that would be dynamic properties, can be “differenced out” averaged out in the long run. Some of these in a way which is analogous to the treatment facts still hold in modern data, as we docu- of fixed effects in econometrics. ment in section 2. The Euler equation approach became the The development of the ideas in the standard approach as it allowed to both test seminal contributions of Modigliani and the validity of the model and to estimate Brumberg and Friedman also led to the some of the structural parameters of the util- realization of other implications. In a simple ity function. A hypothesis that received much version of the life cycle model, if income is attention, since Hall (1978), is that lagged hump shaped and declines at retirement, values of income, or predictable changes in consumers will save when they are young to income, do not predict future consumption support consumption in the last part of life once current consumption is accounted for. and dissave when they are old. Modigliani Perhaps as a consequence of this focus on and Brumberg then showed that this fact can testing, when it came to policy analysis and explain the correlation between aggregate debates, the model and in particular the growth and aggregate saving: growth implies empirical evidence that has been accumu- that, in a given year, younger cohorts, who lated on it have been rarely used. One of the are saving, are “richer” in lifetime terms reasons for this divorce between the litera- than older ones, who are dissaving. The ture on the life cycle model and what should higher the rate of growth is, the larger the have been its practical use in the design and difference in resources between savers and evaluation of public policy stems from the dissavers and, therefore, the higher the fact that the Euler equation does not deliver aggregate rate of saving. a consumption function. While it can be used Attanasio and Weber: Consumption and Saving 695 to test the model and estimate some of its sion of the model that is flexible enough to be parameters, it cannot be used to determine brought in a serious way to the data and that the effects of specific policy changes on con- allows us to derive specific implications on a sumption or saving. number of policy-relevant questions. At the same time, much of the evidence We start our approach by discussing a num- that came to be perceived as the accepted ber of empirical findings in section 2. We refer view pointed to rejections of the life cycle to both time series and cross sectional findings model that took the form of “excess sensitiv- and we focus especially on results that might ity” of consumption to income. Indeed, in point to empirical rejections of the model. We the next section, we take this evidence as one organize our ­discussion of the empirical evi- of the starting points of our discussion of the dence in two parts. We first discuss evidence life cycle model, of its empirical plausibility, that refers to individual consumption behav- and of its utility for policy analysis. We have ior. We then move on to look at evidence two main goals: to take a stand on where the derived from movements in the distribution literature is and what the main issues are and of consumption, which allows researchers to to discuss the public policy implications of look at the functioning of markets and the the life cycle/permanent income models. smoothing of various types of shocks. The life cycle model can be loosely defined After reviewing this empirical evidence, as a framework where individuals maximize we discuss how a relatively standard but suf- utility over time given a set of intertempo- ficiently rich version of the life cycle model ral trading opportunities. Even at this level can be made consistent with it in section 3. of generality, the model is of some useful- Moreover, we discuss the evidence on the size ness. It establishes a conceptual framework of the relevant structural parameters. Having that treats the intertemporal allocation of established that the model is not wildly at resources in a way which is similar to the variance with the data and some of the evi- allocation of resources among different com- dence that was presented as a rejection of the modities. Decisions will then depend on the life cycle model can be reconciled with it if total amount of resources (in the intertem- one specifies a version that is flexible enough, poral context: current and future income as we go ahead and use the model to quantify, by well as current wealth), on preferences over using simulations, its main properties.