Precautionary behavior and consumer information: A Markov process approach

This paper explores the role of consumer confidence in the equilibrium of a dynamic macroeconomic growth model with rational expectations. Consumers face an uncertain future income stream due to a Markov stochastic process that affects production. Changes in the properties of this process change consumer information sets and optimal policies in the rational expectations format. Increases in “persistence” in the shock process are considered; this is identified with the consumer's subjective assessment of future economic conditions. Two cases are considered: where either good or bad states of the process are more likely to persist into the future, and where bad states persist unconditionally at the expense of good. Consistent with earlier treatments of savings under uncertainty (Barsky, Mankiw and Zeldes 1986, and Skinner 1988), the consumer's response to increased income uncertainty is to exhibit precautionary saving behavior. The infinite-horizon growth model format used offers significant improvement over other finite-horizon life cycle models. Specifically, the model is a full general equilibrium model and the solutions are rational expectations solutions. The technique also is easily adapted to other recursive decision problems under uncertainty.