The Permanent Income Hypothesis (PIH) entails that consumption reacts more strongly to persistent than to temporary income shocks.
This prediction is tested using data from the Estonian Household Budget Surveys for 2002-2007. The dataset contains questions which make it possible to distinguish between persistent and temporary income shocks based on the households’ own assessment. The estimations confirm that the marginal propensities to consume out of the two income shocks differ, households are forward-looking and seek to smooth consumption. Moreover, the estimated propensities of persistent shocks are of reasonable magnitudes, consistent with the PIH.
Further analysis reveals, however, features that are in breach of the PIH. The consumption estimations are affected by lagged temporary income shocks. When income shocks are decomposed into positive and negative values, there is evidence of excess sensitivity to positive temporary shocks.
2. Consumption response to income shocks: a brief literature overview
3. Theoretical framework
4. Dataset and identification of income shocks
4.1. The Estonian Household Budget Survey
4.2. Identification of income shocks in the Estonian HBS
5. Consumption estimations
5.1 PIH estimations
5.2 Sensitivity to lagged temporary income shock
5.3 The rule-of-thumb consumption among Estonian households
5.4 Consumption response to positive and negative income shocks
6. Final comments
„Estonia experienced very rapid economic development during the sample years 2002–2007; incomes grew at a fast rate and financing possibilities developed rapidly. In spite of the extraordinary economic changes experienced in Estonia, households appear to have formed expectations and made consumption decisions in ways comparable to experiences from countries with a more stable economic environment. As data are not available from the deep recession experienced by Estonia in 2008–2009, it is not readily examined whether the same pattern continued during the downturn or whether the findings reflect factors that are unique for the upturn.“
The working paper of the bank of Estonia written by Merike Kukk, Dmitry Kulikov, Karsten Staehr
“Consumption Sensitivities in Estonia: Income Shocks of Different Persistence”
Read more from Bank of Estonia website