The Consumption Euler Equation or the Keynesian Consumption Function?*

Abstract

Abstract We formulate a general cointegrated vector autoregressive (CVAR) model that nests both a class of consumption Euler equations and various Keynesian‐type consumption functions. Using likelihood‐based methods and Norwegian data, we find support for cointegration between consumption, income and wealth once a structural break around the time of the financial crisis is allowed for. The fact that consumption cointegrates with both income and wealth and not only with income points to the empirical irrelevance of an Euler equation. Moreover, we find that consumption equilibrium corrects to changes in income and wealth, but not that income equilibrium corrects to changes in consumption, which would follow from an Euler equation. We also find that most of the parameters stemming from the class of Euler equations are not corroborated by the data when conditional expectations of future consumption and income in CVAR models are considered. Only habit formation seems important in explaining Norwegian consumer behaviour. Our estimated conditional Keynesian‐type consumption function implies a first year marginal propensity to consume (MPC) out of income of close to 40%.

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