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GETTING A BETTER UNDERSTANDING OF THE HOUSEHOLD EXPENDITURE FUNCTION AND WHY POLICYMAKERS ARE LOOKING AT THE WRONG THINGS
Key Points
Simple expenditure functions based on a single homogeneous consumption good are wholly inadequate.
How much a household spends will depend on how much they have plus any additional income they may have received from portfolio investments and labor income among other things.
Dynamic stochastic general equilibrium models (DSGE) claim to have microeconomic roots but depart radically upon implementation and their general structures lack any form of descriptive realism.
The Modigliani lifecycle consumption model is probably a good place to start.
When we employ Lars Hansen's recursive techniques, we can develop a model for the household budgeting process which makes sense.
We find that households will be most concerned with their projections of what goods prices, asset prices and their own personal income streams will be in the near future. They will also be concerned with the precision of their forecasts. Forecast variance matters a great deal.
Projected covariances between goods prices, asset prices and income will be of key importance.