Income Adjustments and the Role of Consumers' Durables in Some Leading Consumption Functions

Abstract

In a seminal study Davidson et al. (I978), hereafter DHSY, introduced the error correction form of the consumption function. This has proved to be robust to new data and different time periods - see Hendry (I983) - and has formed the basis of the consumption equations in several macroeconometric models, see Davis (I 984). In subsequent studies Hendry and von Ungern-Sternberg (i 98I), hereafter HUS, and von Ungern-Sternberg (i 98 I) modified the DHSY equation in a number of ways. One of particular interest herein was to redefine the income measure to net out the effect of gains or losses, due to inflation, on liquid assets. We consider here two related potential improvements to these widely used consumption functions. One concerns the appropriate definition of income if there are not only liquid assets which suffer a value loss under certain conditions, but also durable goods which depreciate. The other is related to this and concerns an appropriate specification of the steady-state consumption function, whether static or dynamic, for non-durables (which we take to include services) which recognises the existence of durable consumption goods. It is argued that if care is not taken, the DHSY equation implies a misspecification which leads to an over-estimate of the mean lag relating the consumption of non-durables to income.

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