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This essaywill be discussing what excess sensitivity and excess smoothness is and thedifferent theories associated with them. As well as empirical observations thathave been carried out to try and explain, prove or disprove the differentexplanations of excess sensitivity and excess smoothness such as the retiree’sconsumption puzzle. Then finally look at how theories reconcile with theempirical observations of excess smoothness and excess sensitivity. Smoothnessof consumption can be seen in the Life cycle hypothesis proposed by Modiglianiand Brumberg (1954) as well as the Permanent Income hypothesis proposed byMilton Friedman.  Excess sensitivity is the idea that currentconsumption reacts to past experiences or exogenous shocks. Excesssmoothness refers to the theory that consumption is affected by what ishappening in the present and this information will be used to predict what willhappen tomorrow.

The Lifecycle hypothesis theory states that people attempt to smooth consumption overtheir lifetime. Modiglianiand Brumberg (1954) created the Life cycle hypothesis (LCH) theory that proposesthat consumers maximize their utility by planning their savings and consumptionin a way that the consumption in their lifetime is as smooth as possible.Expanding onthe model, it says that in the earlier stages in of an individual’s life theirexpenses may be higher than their income.

This is because the person is likelyto be making important purchases in relation to trying to start themselves off.Which may include things such as trying to buy a house, starting a family andstarting a new career. To support these expenditure needs they will borrow fromthe future during this stage in their life. After some time however, during themiddle stages of their life; these patterns of spending start to steady and aresupported or surpassed by increases in income. In this moment of time they payback any borrowings and begin to save for their retirement. Once they retire,consumption expenditure is likely to decline but income usually fallsintensely. ThePermanent income hypothesis was proposed by Milton Friedman in 1957 also claimsthe same prediction that people tend to smooth consumption. The fundamentalprinciple of the permanent income hypothesis is that income should not beinfluenced by predicted fluctuations in income but however will be affected bypermanent changes income.

An example would be that during a recession anindividual’s consumption would not see a fall if it was deemed temporary.In 1978Robert Hall tested the Permanent Income Hypothesis. Hall believed Friedman’s(PIH) was correct and introduced his own Random walk theory to support this,which states that If people consumed based on all the information they hadcurrently then past income should not have any influence over currentconsumption in comparison to past consumption. Hall found data to support hisprediction, which he then referred as a slightly altered Permanent IncomeHypothesis. Hall found a way to show if consumption is the outcome of peoplenot being able to optimize it, current consumption must be roughly unpredictablebased on information from the past other than one period lagged consumption.On the otherhand, the retiree’s consumption puzzle refutes both the permanent incomehypothesis and the life cycle hypothesis. Its empirical research has observedthat people who have retired are more likely to reduce their spending once theyhave just retired as well as during their retirement.

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  On the other hand, it may appear thatRetiree’s RPI is likely to surpass general inflation due to the speed that itis increasing which is mainly attributed to factors such as medical care. Theiractual expenditure decreases adjusting for inflation. One of the foundingstudies to support this claim was carried out in the U.K. by Banks, Blundelland Tanner (1998).

They observed a dramatic fall in consumption during retirement.In additionto that there are studies that coincide with the retiree’s consumption puzzleand disprove of the LCH and PIH theory by stating that people are incline tosmooth consumption during their first year of being retired. As seen inBernheim, Skinner and Weinberg (2001) being one of the first studies thenAguilar, Attansio, and Meghir (2011). Through conducting research evidence hasbeen found that in US retiree households non-durable consumption such as foodto be specific, sees a fall once individuals have retired.

Similar empiricalresearch has also been carried out in France by Moreau and Stancanelli (2013),in which the results were the same.There is an ever-increasingnumber of literature that researches a Retirees household spending habits andtendencies. The trend found in most of these studies is that inflation-adjustedconsumption tends to decrease at and during one’s retirement. This is contraryto various economic theories on consumption, e.g. the life-cycle hypothesis(LCH).During the 1990’s,a study by Nicholas Souleles (1999) which gathered sources from refunds ofincome tax was used to test validity of the Permanent Income Hypothesis.

Arefund is dependent upon income from last year, it expected income andtherefore should affect consumption in the year that it is received. Theevidence concludes that consumption is responsive to the income received fromthe refund, with a marginal propensity to consume between 35 and 60%. On top ofthat it was concluded that patterns of social consumption security in Americais not explained well by the PIH, Melvin Stephens (2003).

In 1981Flavin found significant explanations for lagged labour income with regards tocurrent consumption. This was done by presuming that income follows anAutoregressive-moving-average (ARMA) process in which she then calculated thechange in expected permanent income from a change in expected current incomefrom a change in expected current income, which she then concluded thatsensitivity of consumption to changes in current income is significantlygreater than the PIH suggested and rejected Halls (1978) idea; Formulatingpermanent income as the annuity value of the weighted sum of human andnon-human wealth. This led to the rejection of Halls optimization theory and iscalled the “excess sensitivity” puzzle.

One way inwhich we can reconcile theory with the empirical observations of excess sensitivityand excess smoothness is excess sensitivity in consumption without liquidityconstraint.After anin-depth analysis, it has been found that excess sensitivity may not actuallybe best explained by liquidity constraints. It has actually been found byempirical findings that coincide with the theory that various households aredeterred from smoothing their consumption when they believe that the effortthey put in, is going to be less than the welfare they gain. Evidencegathered from household panel data in Asia proposes that excess sensitivity isnot likely to be because of liquidity constraints, regardless of itsassociation with people at an early age, less liquid assets and a lower income.It is probable that these features are in correlation with bad planning ofconsumption.

The difference in the evaluations of excess sensitivity of theAsian financial-crisis beforehand and afterwards can be seen as an indicationthat a handful of households are less incline to make an effort to reachoptimal smoothing during times of growth and prosperity but on the other handmay be more eager to after more difficult times.Another wayin which we can reconcile theories with observations of excess sensitivity and smoothnessis through looking at buffer stock saving. One majorobjective of current consumer theory has been to comprehend and explain thedegree of smoothness and how predictable aggregate consumption is. There haverecently been popular ways of thinking about the way a consumer behaves such asbuffer-stock models with precautionary motives including restrictions toborrowing. On the other-hand research gives little or no evidence of how closebuffer-stock saving behaviour, once accumulated, might quantitatively matchwidely recognised features of aggregate consumption. Results demonstrate thatincomplete information about the feature of individual earnings could be acrucial factor in explaining the smoothness of consumption and how itcorrelates with lagged labour-income growth (excess sensitivity).Anadditional way of reconciling theory with the empirical observations of excesssensitivity and excess smoothness is through explaining consumption excesssensitivity with near rationality using evidence from large predeterminedpayments. From newtransaction data that has been collected it has been shown that consumption canbe excessively sensitive to noticeable, expected, big and consistent paymentsfrom the Alaska Permanent Fund, with a large average marginal propensity toconsume (MPC) being 70% of total expenditure and 30% for services andnon-durable goods and services.

Households who fail to smooth consumption inrespect of equivalent variations are the ones who deviate from the standardinter-temporal consumption model. Particularly the size of the loss ofhousehold income is decreased as the MPC is increasing. As a result, householdsare consistent with following near-rational varied plans of consumption asstatistically, substantial excess sensitivity is responsive to large payments.

Near rational possibilities may be more realistic behaviour than the standardconsumption model. The newpredictor has an explanation for excess sensitivity with respect to householdswho have a larger income, which coincides with near-rational deviations fromthe permanent-income life-cycle theory. The MPC can be reduced from 80% to 15%by moving up from the lowest quintile to the highest. The loss that can occuris influenced by liquid asset, age, income and education.The lossesthat can occur is an explanation for the MPC for households without borrowingconstraints. Research showed that this is occurred with most of the households,whilst acknowledging how they responded to dividends.

This meant thathouseholds were happy to give up a day of less consumption every year to fullysmooth the dividend. The results gained from observation of the data isconsistent with near-rational behaviour.       To concludewe can reconcile theory with empirical observations of excess smoothness andsensitivity that is widely observed by looking at recent research conducted suchas consumption without liquid constraint and excess sensitivity withnear-rationality and drawing conclusions from them.