Can Consumers Distinguish Persistent from Transitory Income Shocks?
One of the most widely used income processes in Economics is one in which households face both permanent and transitory income shocks.1 While this income process has been argued to represent income data fairly well, little is known about households ability to distinguish between these two types of shocks. The assumption that households can perfectly distinguish between permanent and transitory shocks, and thus know their own permanent income, is so standard in Eco- nomics, that it is rarely stated explicitly, let alone tested empirically. This is, however,not an innocuous assumption, but have implications for our interpretation of observed consumption-saving behavior. At least since Friedman's Permanent Income Hypothesis in the 1950s it has been understood that transitory income shocks should only render a small adjustment in household consumption-saving behavior, while permanent income shocks should lead to a significant change in consumption. Clearly, this relies heavily on the ability of consumers to distinguish between permanent and transitory income shocks. In a recent survey, Blundell (2014) thus asks for research on \the consumer's ability to distinguish between permanent and transitory shocks" (p. 312). We want to expand the current international research frontier on this highly relevant topic by asking: Can Consumers Distinguish Persistent from Transitory Income Shocks?