Using Subjective Income Expectations to Test for Excess Sensitivity of Consumption to Predicted Income Growth

We test for excess sensitivity of consumption to predicted income growth using a 1989–93 panel survey of Italian households that includes measures of subjective income and inflation expectations. These expectations provide a powerful instrument for predicting income growth. Controlling for the expected variance of consumption growth and for predictable changes in labour supply, we find that household consumption growth is very strongly correlated with predicted earnings growth of the head. We also find considerable evidence that excess sensitivity is due to liquidity constraints. Our strongest result is that in a sample of low-asset households the coefficient of expected income increases is one, while that of expected income declines is zero.