Jeppe Druedahl and Thomas H. Jørgensen’s paper entitled “Can Consumers Distinguish Permanent from Transitory Income Shocks?”
has been accepted for publication in The Economic Journal.
The degree to which consumers can distinguish persistent from transitory income shocks is paramount for consumption-saving dynamics. In particular, even a small amount of imperfect information causes a severe bias in conventional estimators of the marginal propensity to consume. We provide a novel method which can identify the consumers’ degree of information using panel data on income and consumption even allowing for measurement error. Employing our method to data from the Panel Study of Income Dynamics, we find that households have almost perfect information. This robust result indicates that the conventional estimators of the marginal propensity to consume are on firm ground.