Are Consumers’ Spending Decisions in Line With an Euler Equation?

By Lena Dräger and Giang Nghiem

http://d.repec.org/n?u=RePEc:jgu:wpaper:1802&r=dge

Evaluating two new survey datasets of German consumers, we test whether individual consumption spending decisions are formed according to an Euler equation derived from consumption life-cycle models. Measured in qualitative individual changes, our results suggest that current and planned spending are positively correlated, thus supporting the hypothesis of consumption smoothing. Also, current spending is positively correlated with inflation expectations, and negatively with nominal interest rate expectations. Interestingly, the effect of perceived real interest rates is only significant for financial market participants, financially unconstrained households and those with high financial literacy, implying that these are important conditions for the ability to smooth consumption over time. Moreover, these households are better positioned in the wealth and income distributions. In that sense, the ability to smooth consumption may be a channel through which distributional effects of policy shocks may occur. Finally, news on inflation and monetary policy observed by the consumer strengthen the effect of their inflation expectations on current spending, suggesting that imperfect information may also influence the Euler equation relationship.

There are many papers estimating Euler equations, but they usually do it on aggregate data. This paper uses two German surveys and it is with great relief that we learn that the consumption Euler equation is still working well.

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