Explaining Aggregate Consumption...
In the 1980s, John's research interests shifted to the macroeconomics of consumption and the role of the open economy, building on his microeconomic work on consumption and aggregation.
This occurred against a backdrop of large macroeconomic and exchange rate cycles in the UK. Hall (1978), in his landmark paper on the implications of the LCH/PIH model of consumption under rational expectations and the absence of credit constraints, showed that the intertemporal optimality condition, the Euler equation, implied that the growth rate of consumption should be unpredictable.[209] Muellbauer (1983) tested this consumption model on UK data and rejected Hall's hypothesis. After accounting for a structural break associated with the shift from fixed to flexible exchange rates in 1971, he found instead that important marginal information about consumption was contained in lagged consumption and lags in income. The rejection could not be attributed to either time variation in the real interest rate or to violations of the perfect credit markets assumption in the form of shifts in the proportion of credit-constrained households. This led John to suspect that other factors, such as household balance sheets, were involved; a more complete specification of a consumption function was necessary to be consistent with aggregate time-series data.In a related paper, Muellbauer (1988) investigated whether habit formation in consumption could explain why consumption was sensitive to past lags of income in the presence of lagged consumption. Habit describes the notion that the utility from consumption in a period depends to a significant extent on consumption levels in surrounding periods. He tested two forms of habit formation, one he dubbed rational and the other, myopic, and found evidence supporting the latter. This inspired John to work further on modelling consumption allowing for lagged adjustment towards target or equilibrium consumption and to apply equilibrium- or error-correction models of timeseries consumption, in extensions of the Davidson et al. (1978) equilibrium correction model for consumption.
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