Consumption: innovation persistence and the excess smoothness debate
Based on studies using US data, consumption is too smooth relative to the implications of the rational expectations permanent income hypothesis (REPIH) of consumption. We examine this and a number of related methodologicalissues for the UK using maximum likelihood estimation (MLE) of an autoregressive fractionally integrated moving average (ARFIMA) model of the income process. We conclude that an innovation to income has a persistent effect on consumption and that, in contrast to the findings from US studies, consumption is too volatile compared to the REPIH model. Further, MLE is substantially more efficient than the semi-parametric method of estimating ARFIMA models which has previously been used in this area.