Credit Constraints, Learning and Aggregate Consumption Volatility

This paper documents three empirical facts. First, consumption volatility relative to income volatility rose from 1947-1960 and then fell dramatically by 75 percent from the 1960s to the 1990s. Second, the correlation between consumption growth and personal income growth fell by about 75 percent over the same time period. Finally, absolute deviations of consumption changes from their mean exhibit two breaks in U.S. data, and the mean size of the absolute deviations has again fallen by about 75 percent. First, I \u85nd that a standard benchmark permanent income hypothesis model is unable to explain these facts. Then, I examine the ability of two hypotheses: a fall in credit constraints and changing beliefs about the permanence of income shocks to explain these facts. I \u85nd evidence for both explanations and \u85nd that these facts can be almost completely explained by a model with learning about the nature of income shocks and a reduction in credit constraints. Importantly, I \u85nd that estimated changes in beliefs about the permanence of income shocks have substantial explanatory power for consumption changes