Abstract: The existence of durable goods implies that the welfare flow from consumption cannot
be directly associated with total consumption expenditures. As a result, tests of
standard theories of consumption (such as the Permanent Income Hypothesis, or PIH)
typically focus on nondurable goods and services. Specifically, these studies
generally relate real consumption of nondurable goods and services to measures
of real income and wealth, where the latter are deflated by a price index for total
consumption expenditures. We demonstrate that this procedure is only valid under
the assumption that real consumption of nondurables and services is a constant multiple
of aggregate real consumption outlays--an assumption that represents a very poor
description of U.S. data. We develop an alternative approach that is based on the
observation that the ratio of these series has historically been stable in nominal
terms, and use this approach to examine two basic predictions of the PIH. We obtain
significantly different results relative to the traditional approach.
Keywords: Permanent income hypothesis, consumption deflation
Full paper (275 KB PDF)
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Last update: September 4, 2002
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