The present study aims to evaluate the aggregate consumption function from the perspective of the Euler equation using Indian macroeconomic data. Further, to examine the robustness of the findings for India, other developing nations are also studied.
Quarterly time-series data from 1996:1 to 2020:3 on consumption and income in India are used to evaluate the alternative model proposed by Campbell and Mankiw (1989). The alternative hypotheses in the present study are tested by estimating models using the instrumental variable approach. The lagged changes in the quarterly average of 91-day Treasury bill yields are used as the nominal interest rate instrumental variables along with other lagged instrumental variables.
The evidence presented in this study suggests that aggregate consumption is better explained when the permanent income model incorporates rule-of-thumb consumers, that is, individuals who consume their current income along with those who consume their permanent income.
The new rule-of-thumb framework better explains some of the observed phenomena, such as why the expected changes in consumption are related to the expected changes in income, why the expected changes in consumption are unrelated to real interest rates (i.e. why the intertemporal elasticity of substitution is near zero) and why a high consumption/income ratio is usually followed by an increase in income growth.
This study adds to the limited literature on the Euler-based consumption function in developing economies.
