Consumer Confidence and Rational Expectations: Are Agents' Beliefs Consistent with the Theory?

Using U.K. data, the rational expectations permanent income hypothesis is rejected due to the predictive content of consumer confidence and not labor income or any other macroeconomic variable. The authors provide evidence suggesting that this cannot be explained by liquidity constraints and account for this finding in terms of precautionary saving. Extending the consumption capital asset pricing model to allow a time varying conditional variance, they find a high level of confidence is associated with greater optimism about the level of consumption but also a higher forecast variance. Allowing for time aggregation, the overidentifying restrictions implied by this model are accepted. The authors estimate a small but statistically significant intertemporal elasticity of substitution. Copyright 1994 by Royal Economic Society.