This essay
will be discussing what excess sensitivity and excess smoothness is and the
different theories associated with them. As well as empirical observations that
have been carried out to try and explain, prove or disprove the different
explanations of excess sensitivity and excess smoothness such as the retiree’s
consumption puzzle. Then finally look at how theories reconcile with the
empirical observations of excess smoothness and excess sensitivity.

Smoothness
of consumption can be seen in the Life cycle hypothesis proposed by Modigliani
and Brumberg (1954) as well as the Permanent Income hypothesis proposed by
Milton Friedman.

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 Excess sensitivity is the idea that current
consumption reacts to past experiences or exogenous shocks.

Excess
smoothness refers to the theory that consumption is affected by what is
happening in the present and this information will be used to predict what will
happen tomorrow.

The Life
cycle hypothesis theory states that people attempt to smooth consumption over
their lifetime.

Modigliani
and Brumberg (1954) created the Life cycle hypothesis (LCH) theory that proposes
that consumers maximize their utility by planning their savings and consumption
in a way that the consumption in their lifetime is as smooth as possible.

Expanding on
the model, it says that in the earlier stages in of an individual’s life their
expenses may be higher than their income. This is because the person is likely
to be making important purchases in relation to trying to start themselves off.
Which may include things such as trying to buy a house, starting a family and
starting a new career. To support these expenditure needs they will borrow from
the future during this stage in their life. After some time however, during the
middle stages of their life; these patterns of spending start to steady and are
supported or surpassed by increases in income. In this moment of time they pay
back any borrowings and begin to save for their retirement. Once they retire,
consumption expenditure is likely to decline but income usually falls
intensely.

The
Permanent income hypothesis was proposed by Milton Friedman in 1957 also claims
the same prediction that people tend to smooth consumption. The fundamental
principle of the permanent income hypothesis is that income should not be
influenced by predicted fluctuations in income but however will be affected by
permanent changes income. An example would be that during a recession an
individual’s consumption would not see a fall if it was deemed temporary.

In 1978
Robert Hall tested the Permanent Income Hypothesis. Hall believed Friedman’s
(PIH) was correct and introduced his own Random walk theory to support this,
which states that If people consumed based on all the information they had
currently then past income should not have any influence over current
consumption in comparison to past consumption. Hall found data to support his
prediction, which he then referred as a slightly altered Permanent Income
Hypothesis. Hall found a way to show if consumption is the outcome of people
not being able to optimize it, current consumption must be roughly unpredictable
based on information from the past other than one period lagged consumption.

On the other
hand, the retiree’s consumption puzzle refutes both the permanent income
hypothesis and the life cycle hypothesis. Its empirical research has observed
that people who have retired are more likely to reduce their spending once they
have just retired as well as during their retirement.  On the other hand, it may appear that
Retiree’s RPI is likely to surpass general inflation due to the speed that it
is increasing which is mainly attributed to factors such as medical care. Their
actual expenditure decreases adjusting for inflation. One of the founding
studies to support this claim was carried out in the U.K. by Banks, Blundell
and Tanner (1998). They observed a dramatic fall in consumption during retirement.

In addition
to that there are studies that coincide with the retiree’s consumption puzzle
and disprove of the LCH and PIH theory by stating that people are incline to
smooth consumption during their first year of being retired. As seen in
Bernheim, Skinner and Weinberg (2001) being one of the first studies then
Aguilar, Attansio, and Meghir (2011). Through conducting research evidence has
been found that in US retiree households non-durable consumption such as food
to be specific, sees a fall once individuals have retired. Similar empirical
research has also been carried out in France by Moreau and Stancanelli (2013),
in which the results were the same.

There is an ever-increasing
number of literature that researches a Retirees household spending habits and
tendencies. The trend found in most of these studies is that inflation-adjusted
consumption tends to decrease at and during one’s retirement. This is contrary
to various economic theories on consumption, e.g. the life-cycle hypothesis
(LCH).

During the 1990’s,
a study by Nicholas Souleles (1999) which gathered sources from refunds of
income tax was used to test validity of the Permanent Income Hypothesis. A
refund is dependent upon income from last year, it expected income and
therefore should affect consumption in the year that it is received. The
evidence concludes that consumption is responsive to the income received from
the refund, with a marginal propensity to consume between 35 and 60%. On top of
that it was concluded that patterns of social consumption security in America
is not explained well by the PIH, Melvin Stephens (2003).

In 1981
Flavin found significant explanations for lagged labour income with regards to
current consumption. This was done by presuming that income follows an
Autoregressive-moving-average (ARMA) process in which she then calculated the
change in expected permanent income from a change in expected current income
from a change in expected current income, which she then concluded that
sensitivity of consumption to changes in current income is significantly
greater than the PIH suggested and rejected Halls (1978) idea; Formulating
permanent income as the annuity value of the weighted sum of human and
non-human wealth. This led to the rejection of Halls optimization theory and is
called the “excess sensitivity” puzzle.

One way in
which we can reconcile theory with the empirical observations of excess sensitivity
and excess smoothness is excess sensitivity in consumption without liquidity
constraint.

After an
in-depth analysis, it has been found that excess sensitivity may not actually
be best explained by liquidity constraints. It has actually been found by
empirical findings that coincide with the theory that various households are
deterred from smoothing their consumption when they believe that the effort
they put in, is going to be less than the welfare they gain.

Evidence
gathered from household panel data in Asia proposes that excess sensitivity is
not likely to be because of liquidity constraints, regardless of its
association with people at an early age, less liquid assets and a lower income.
It is probable that these features are in correlation with bad planning of
consumption. The difference in the evaluations of excess sensitivity of the
Asian financial-crisis beforehand and afterwards can be seen as an indication
that a handful of households are less incline to make an effort to reach
optimal smoothing during times of growth and prosperity but on the other hand
may be more eager to after more difficult times.

Another way
in which we can reconcile theories with observations of excess sensitivity and smoothness
is through looking at buffer stock saving.

One major
objective of current consumer theory has been to comprehend and explain the
degree of smoothness and how predictable aggregate consumption is. There have
recently been popular ways of thinking about the way a consumer behaves such as
buffer-stock models with precautionary motives including restrictions to
borrowing. On the other-hand research gives little or no evidence of how close
buffer-stock saving behaviour, once accumulated, might quantitatively match
widely recognised features of aggregate consumption. Results demonstrate that
incomplete information about the feature of individual earnings could be a
crucial factor in explaining the smoothness of consumption and how it
correlates with lagged labour-income growth (excess sensitivity).

An
additional way of reconciling theory with the empirical observations of excess
sensitivity and excess smoothness is through explaining consumption excess
sensitivity with near rationality using evidence from large predetermined
payments.

From new
transaction data that has been collected it has been shown that consumption can
be excessively sensitive to noticeable, expected, big and consistent payments
from the Alaska Permanent Fund, with a large average marginal propensity to
consume (MPC) being 70% of total expenditure and 30% for services and
non-durable goods and services. Households who fail to smooth consumption in
respect of equivalent variations are the ones who deviate from the standard
inter-temporal consumption model. Particularly the size of the loss of
household income is decreased as the MPC is increasing. As a result, households
are consistent with following near-rational varied plans of consumption as
statistically, substantial excess sensitivity is responsive to large payments.
Near rational possibilities may be more realistic behaviour than the standard
consumption model.

The new
predictor has an explanation for excess sensitivity with respect to households
who have a larger income, which coincides with near-rational deviations from
the permanent-income life-cycle theory. The MPC can be reduced from 80% to 15%
by moving up from the lowest quintile to the highest. The loss that can occur
is influenced by liquid asset, age, income and education.

The losses
that can occur is an explanation for the MPC for households without borrowing
constraints. Research showed that this is occurred with most of the households,
whilst acknowledging how they responded to dividends. This meant that
households were happy to give up a day of less consumption every year to fully
smooth the dividend. The results gained from observation of the data is
consistent with near-rational behaviour. 
      

To conclude
we can reconcile theory with empirical observations of excess smoothness and
sensitivity that is widely observed by looking at recent research conducted such
as consumption without liquid constraint and excess sensitivity with
near-rationality and drawing conclusions from them.

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