The Consumption Function and the Life-Cycle Hypothesis: An Analysis of Norwegian

Household Data
Author(s): Erik Biørn
Source: The Scandinavian Journal of Economics , 1980, Vol. 82, No. 4 (1980), pp. 464-480
Published by: Wiley on behalf of The Scandinavian Journal of Economics

Stable URL: https://www.jstor.org/stable/3439678

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THE CONSUMPTION FUNCTION AND THE
LIFE-CYCLE HYPOTHESIS: AN ANALYSIS
OF NORWEGIAN HOUSEHOLD DATA*

Erik Biorn

Central Bureau of Statistics, Oslo, Norway

Abstract

The Modigliani-Brumberg life-cycle hypothesis, with a utility function of the Stone-

Geary form with age-dependent parameters, is used to analyze the relationship
between consumption expenditure, income and wealth on the micro level. By
utilizing information on the composition of income by source, a distinction is made
between permanent and transitory income. The model is estimated from Norwegian
cross-section household data from the year 1973. The estimates are compared with
simple regression estimates on the same data. Additional results, illustrating the
sensitivity of the conclusions with respect to some of the main assumptions, are
also reported. The applicability of the results in macroeconomic work is briefly
discussed.

I. Introduction

The "new theories" of the consumption function set out by Modigliani &
Brumberg (1955) and Friedman (1957) more than 20 years ago accentuate the
role of households' long-term income expectations, as opposed to currently
observed income, in explaining consumer demand. One of the main postulates
of Friedman's permanent income hypothesis is that changes in observed in-
come influence consumption only to the extent that they affect "long-term",
or "permanent", income; transitory income changes only affect saving. The
Modigliani-Brumberg life-cycle hypothesis has a similar implication; the mar-
ginal propensity to consume of transitory income, although positive, is far
less than that of permanent income; Modigliani & Brumberg (1955, p. 405)
and Mayer (1972, pp. 29-31).
This paper is concerned with the estimation of consumption functions from
Norwegian cross-section data within the framework of the life-cycle hypothesis.
According to this theory, age differences account for a substantial share of

* A preliminary version of this paper was presented at the Nordic Meeting of Economists,
Helsingor, Denmark in June 1979. I am grateful to Olav Bjerkholt, Svein Longva and
an anonymous referee for useful comments.

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 Consumption function and the life-cycle hypothesis 465

individual differences in consumption. This makes the theory particularly well

suited to confrontation with micro data. It may be contested, of course,
whether cross-section data are adequate when dealing with dynamic aspects of
consumer behavior; ideally, the life-cycle model requires individual time series
of consumption expenditures, income, income expectations, saving and wealth
for a period covering the consumer's entire horizon span. Today, however,
this is clearly an unrealistic claim, as the strict version of the model lets the
horizon span be the (expected) remaining lifetime, which will usually exceed
25 years for the average consumer. In this situation, we may either completely
dismiss the life cycle model as a basis for interpreting existing micro data, or,
while waiting for more suitable data to appear, revise the model according
to the data actually at our disposal. One of the primary aims of this paper is
to give an example of such a reformation.
The theoretical model, which is an extension of models previously applied
by Modigliani & Brumberg (1955) and Somermeyer & Bannink (1973), is
presented in Section II. Particular attention is paid to its implications con-
cerning the income marginal propensity to consume. Section III contains a
brief description of the data, while Section IV deals with econometric refor-
mulation of the model to make it operational with the data at hand. The main
problems discussed in this section are parametrization of the effect of age and
the choice of indicators of permanent and transitory income. The empirical
results are presented in Section V. Finally, in Section VI, we summarize the
findings, comment on their applicability in macroeconomic work and suggest
topics for further research.

II. The Model: General Description

We assume that the household's planning process can be described adequately

by solving a problem of constrained utility maximization over a given finite
horizon span. Consider a household with a horizon span of T years. The head
of the household, i.e. the person who makes the consumption decisions on
behalf of the household, is A years old. A reasonable hypothesis-even if we
have little empirical evidence to support it-is that the plans of young persons
are normally more long range than those of older people. We therefore assume
that T is a decreasing function of A, to be denoted by T(A).
Let Ct be the volume of total consumption in year t(t = 1, 2, ..., T), where
the current year is assigned the number 1. We assume that the household
has a utility indicator of the following strongly separable form:
T(A)

U(C1, C2, ..., CT(A); A) = y yt(A) log {Ct - flt(A)}, (1)

t=l

where y2(A) (>0) and flt(A) are age-dependent parameters. Th

these parameters may also depend on the number of household members, the

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466 E. Bi0rn

social status of the head of the household and other background variables.
Mathematically, (1) is identical with the Stone-Geary (Klein-Rubin) utility
function, which is frequently used in empirical research dealing with the alloca-
tion of total consumption expenditures to the different goods within the static
one-period framework. It is then somewhat surprising that this function has
evoked little attention from authors dealing with the allocation of consumption
and saving over time. In their seminal study on the life-cycle hypothesis,
Modigliani & Brumberg (1955, pp. 395-396) restricted the utility function to
be homothetic. The log-linear utility function, i.e. the specification with

flt(A) =0 for all t, was adopted by Somermeyer & Bannink (1973, Ch

Analogous with the usual interpretation of the Stone-Geary utility function
in connection with static models of allocation, flt(A) may be interpreted as
the "minimum consumption" in year t of a household with (a head of) age A
at the start of the planning period, while ye*(A) represents its "urgency"
consume in excess of this minimum.
The household faces the budget constraints

Wt=Wt-.+Ye*-Ct (t=1,2, ...IT),

where Yt* is real income (net of taxes) in year t, and Wt is the real valu
total net wealth at the end of year t. Let Yt denote the predetermined part o
income in year t, i.e. income excluding the part which is due to saving deci-
sions from the start of the planning period up to the beginning of year t:

Yt = Ye -r( Wt 1WO),

where r is the interest rate. Predetermined income includes wage income,

income from social security schemes, income from initial wealth (r WO),
The budget constraint in year t can then be written as

Wt - WO = (1 +r) (Wt-_1-WO) + Yt-Ct (t = 1, 2, ..., T), (2)

provided that the interest rate is (expected to be) the same in all T years.
From (2) we obtain the overall budget constraint

T(A)

E (Ye- Ct) (1 + r) (A)t= WT(A) - WO, (3)

t=1

where WT(A) is the terminal value of wealth, assumed to be exogenously given

in the model. Disregarding credit market imperfections and other institutional
constraints, which may restrict (positive or negative) saving, (3) is the only
effective restriction on the household's dispositions.
Instead of assuming that WT(A) is exogenous, we could have included this
variable as a positive argument in the utility function. This assumption may

1 However, they also mention the Stone-Geary specification as a possible generalizati

See also Lluch (1973).

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 Consumption function and the life-cycle hypothesis 467

be interpreted in at least two ways. First, if T(A) is associated with expected

remaining lifetime, positive evaluation of terminal wealth may reflect un-
certainty with respect to actual lifetime. Second, even if the lifetime were
known with certainty, the "bequest motive" may explain the desire to have
positive wealth at the end.'
The first-order conditions for maximizing (1) subject to (3) are

OC, aCt yt*(A) C1,- #,(A)=(~~- t2 T

Combining these with the budget constraint (3) and solving for Ct we get the
"demand functions"

' T(A)
Ct =t(A) + yt(A) I

(t= 1,** T(A)), (4)

where
/T(A)

yt(A) = Ye (A) /2 ys*(A) (t = 1, ... ., T(A)).

The marginal propensities to consume (MPC) of the different income compo.

nents and "surplus wealth" are, respectively:

a = yt(A) (1 + r)t-s (t, s= 1, ..., T(A)), (5)

aS

act- W)yt(A) (1 + r)t T(A) (t = 1 Tl(A)). (6)

We note the following implications: 1) All MPC's have an order of magnitude

equal to the inverse of the length of the planning period (recalling that
9t yt(A) = 1). 2) The MPC's of initial wealth are decreasing functions of th
length of the planning period, i.e. increasing functions of age, since both
factors on the r.h.s. of (6) will in general decrease with increasing T. 3) An
increase in the interest rate will reduce all MPC's of initial wealth except
aCTI@WO, which is unaffected. 4) An increase in the interest rate will leave
GCtl/ Yt unaffected and increase or reduce aCta/ Ys according to whether s is
less than or greater than t.
In year 1, when the household makes its consumption plans, income Y,
and initial wealth WO are known. Current and future consumption also depend
on the value planned for terminal wealth WT(A) and the household's expecta-
tions with respect to future income, Y2, Y3, .. YT. We assume that these
expectations are formed in the following way. The household splits its current

1 Cf. Somermeyer & Bannink (1973, p. 53). See also Friedman (1957, pp. 16-17) and
Modigliani & Brumberg (1955, pp. 392-393).

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468 E. Biorn

income observed Y1 into two components, a permanent part YP and a

part yT. These components have "elasticities of expectation" equal to unity
and zero, respectively, i.e. changes in YP induce proportional changes in the
household's expectations with respect to income in all future years, whereas
changes in yT do not affect these expectations at all. We formalize this as
follows:

y1 _ yP+ yT

Y, = h,(A) YP (s =2, 3, ...,) T(A)), (7)

where the functions hU(A) represent the exp

hold with a head of age A and a permanent income of YP today expects to
receive an income equal to h3(A) YP when its head is A +s years old. Sub-
stituting (7) into (4), the consumption function for the current year takes the
form
T(A)

C = 41(A) - V(A) :E Als(A) (I + r)'-"

8=l

T(A)

+ yl(A) 11 + IZ hs(A) (1 + r)'-s YP + yl(A) yT

s=2

+ yl(A) (1 + r)l-T(A) (W0 - WM)), (8)

where, for notational simplicity, we omit the subscript on C.

Consider, as an illustration, the case where permanent income is expected
to grow at an age-independent rate g, that is h,(A) = (1 +g)S-1 for all A and
The MPC of permanent income (the long-term MPC) would then become

(+g)T(A)

F = 1(A) + g for gtr,

y1(A) T(A) for y= r.

This is an increasing function of the rate of income growth and a decreasing

function of the interest rate.' If, for instance, yl(A) = 1/T(A), r = 0.02,
g =0, the value of aClG YP is equal to 0.91 when T = 10 and equal to 0.81 w
T =20.
The consumption function (8) is linear in permanent income, transitory
income and the difference between initial and terminal wealth. The MPC of
transitory income has an order of magnitude of 1/T(A) in relation to the
MPC of permanent income. This implies that the relative importance of

1 However, since an increase in r will increase YP (as rW0 is one of its componen
model is ambiguous as regards the sign of the effect of interest changes on consumption
and saving. The income and substitution effects have opposite signs.

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 Consumption function and the life-cycle hypothesis 469

transitory income increases with age. If WT(A) =0, i.e. the total value of initial
wealth is used for consumption during the planning period, the MPC of wealth
is equal to the MPC of transitory income multiplied by the discounting factor
(1 +r)1-T(A). At the other extreme, if the household plans to have the same
real value of wealth at the end as it had at the beginning (WT(A) = WO), the
wealth term vanishes. In this case, wealth affects consumption only indirectly,
through wealth income (recall that rW0 is a component of YP). These implica-
tions are certainly strong, but not implausible.

III. The Data

The data base has been constructed by combining information from two
sources. The file of consumption data contains reports from a sample of Nor-
wegian households based on mixed interview and expenditure accounting
during a two-week period in 1973. The data on income and wealth of the
persons in these households are taken from individual tax returns for the
income year 1973. The two data files, comprising a total of 3 271 complete
household reports, have been processed by the Norwegian Central Bureau of
Statistics in connection with preparation of the Survey of Consumer Expendi-
ture and Income and Property Statistics of 1973.1
On the basis of the detailed specification in the income data file, we defined
the following aggregates: wage income, income from social security schemes,
entrepreneurial income, income from real and financial assets net of debt
interests, and capital gains.2 This information is then used to construct in-
dicators of permanent and transitory income as described in Section IV below.
To satisfy the model assumption that all income variables are disposable in-
comes, we allocate-for each household-the total value of net direct taxes
to the different income components by assuming that all components are sub-
ject to the same average tax rate. The wealth variable is represented by the
total value of real and financial assets, as reported to the tax authorities,
minus the total value of debt.
Needless to say, our data are not ideally suited to the theoretical framework
of the model. First, the lack of coincidence between the registration period
for income and consumption expenditures will certainly lead to errors in the
measurement of saving. Second, the values of physical capital assets as esti-
mated by the tax authorities normally underestimate the market values. In
spite of these deficiencies, the overall quality of our data is hardly inferior to
that of pure interview data. Such data, which are applied by most other
researchers in this field, inevitably contain substantial margins of error.

1 See CBS (1975, 1977 a, 1977b) for further details.

2 Details are given in Biorn (1979, Ch. 2).

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470 E. Bi0rn

IV. The Model: Econometric Specification

Reformulation of the model to permit econometric estimation from the data

at hand raises several problems. In this section, we comment briefly on our
solution to the six most important problems.
The first concerns the relationship between the consumer's horizon span and
his age, the function T(A). The length of a household's planning period is not
easily observable, if at all measurable. The only information available is the
relationship between expected remaining lifetime-which is almost certainly
positively correlated with this variable-and age. Using life tables for men,'
constructed by the Norwegian Central Bureau of Statistics on the basis of
death rates for the years 1973-1974, we estimate the following regression to
be used in the model:

T = 70.3985 -0.751762A -0.00678987A2+ 0.0000769838A3. (9)

This gives an almost perfect fit for ages between 20 and 80 years (i.e. an age
span which covers nearly all of the households in the sample). Whenever the
model specification requires T(A) to be an integer (see e.g. eq. (8)), the value
calculated from (9) is replaced by its integral component.
Second, the (real) interest rate r is set equal to 2.5 per cent p.a. for all
households. This is a compromise estimate based on observed market rates of
interest, the average rates of return on financial assets and the rate of debt
interest estimated from the sample. Several arguments in support of indi-
vidualizing interest rates could be given-if reliable observations were at hand.
Individual rates of return estimated from oui 1973 sample would be of little
use, however, since r is assumed to be an expected long-term interest rate.
Our third problem concerns the definition of permanent and transitory in-
come. Common sense reasoning suggests that future values of wage income,
income from social security schemes and "normal" return on wealth are the
most easily predictable income components. Of course, both wage income and
social security income include transitory components. These components, how-
ever, are probably negatively correlated. For instance, if a person could not
work for some part of the year due to illness or unemployment, his wage income
would be less than normal. But his social security grants would then exceed
their normal level, so that the sum of the two transitory income components
is likely to be small. The prediction of entrepreneurial income is more difficult;
its transitory component is not negligible. Capital gains and wealth income
in excess of "normal" return are largely random. Simplifying this general
hypothesis, we define our income variables as follows:

1 Unfortunately, the sex of the head of household is not specified in our data file. The
error made by proceeding as if all housholds were headed by men is probably of minor im-
portance compared with other errors committed.

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 Consumption function and the life-cycle hypothesis 471

YP = wage income

+income from social security schemes

+a x entrepreneurial income

+ r x total net wealth,

YT = (1 -a) x entrepreneurial income

+ (total net wealth income - r x total net wealth)

+ capital gains,

where a, the permanent part of entrepreneurial income, is estimated so as to

give a sample mean of yT equal to zero. This implies a=0.6724, i.e. about
two-thirds of entrepreneurial income is allocated to permanent and one-third
to transitory income.'
Fourth, the model requires parametric specification of the functions
f,(A), ...,--(A) and y,(A). We assume that minimum consumption grows
geometrically by a factor ,u pro anno and that its level in the current year,
41(A), is a quadratic in the number of persons in the household (N) and the
age of its head (A):

flt(A) = flt(A; N) = jt-l{flo +fNN +PNNN2 +PAA +flANAN ?PAAA2}

(t = ,.. T(A)). (10)

Note that this implies nonstationarity of consumption habits. Stationarity

would hardly be a plausible assumption in view of the changes in consumption
habits and in the general standard of living experienced by the households
over time. Assumption (10) also implies that the household ignores possible
changes in household composition over time.
The parametrization of yl(A), indicating (relative) urgency to consume in
the current year, is the same as that of Modigliani & Brumberg (1955, p. 397)
i.e.

yj (A)= (A).(11)

Of course, this assumption is rather restrictive, as it implies, inter alia, that the
marginal propensity to consume of transitory income is equal to the inverse
of expected remaining lifetime.2
Our fifth problem concerns specification of the function h3(A), the expected

1 Note that our way of using the terms permanent and transitory income differs in some
respects from that of Friedman (1957). He does not, however, give a clear and consistent
definition of these concepts. See also Tobin (1975, pp. 115-120).
2 Our assumptions regarding Plt and yj are, in a sense, the opposite of those u
meyer & Bannink (1973, Chs. 6.3-6.4). They let all flt equal zero, i.e. do not allow for a
constant term in the consumption function. On the other hand, their yj is assumed to
depend not only on age, but also on type of household and several socio-economic back-
ground variables.

31 -804818 Scand. J. of Economic. 1980

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472 E. Biorn

income-age profile of the household. We assume that this function can be

written as the product of two factors, a general growth factor and an age-
specific factor,

hs(A) = (1 +g)8-'F(s -1, A) (s = 2, 3, ..., T(A)), (12)

where g is independent of age. The function F simulates the normal life-cycle

income pattern. It is estimated from the sample in the following way. We
approximate the values of YP to a quadratic in N and A with dummy shifts
in constant term to capture differences in income level according to the oc-
cupational status of the head of household.' Using simple regression, we obtain

YP = D(A) = o(A; N) = constant +260.42A -5.39A2+2095.50N

- 768.94N2 + 199.55AN.

The maximum of this function is attained at ages of about 43, 61 and 80

years for one-, two- and three-person households, respectively. We set F(s, A)

equal to O'(A +s)/1(A), implicitly assuming that the number of household

members does not change over time, or rather, that such changes are not
anticipated by the household.2 Of course, the form of the income-age profile
may change over time, as it may be subject to e.g. changes in economic policy.
Moreover, the income-profile of a household is conceptually more intricate
than that of a single person. Still, (12) may give a useful representation of
the expectation formation of a household which is in a planning situation,
even if it is inappropriate as an ex post description.
The sixth, and final, problem is the choice of assumption with respect to
terminal wealth, WT(A). With only cross-section data at hand and no informa-
tion on intended bequest behavior, this is no easy problem to solve. Disregard-
ing the "bequest motive", a terminal value of zero would seem sensible as far
as financial assets are concerned. To make a similar assumption when real
assets account for a substantial part of total net wealth would be more ques-
tionable. Although the ownership of real assets is one of the main bases for
obtaining credit, a zero net wealth position would be difficult to attain in
practice because of credit market imperfections, illiquidity of real assets, etc.
Nevertheless, we choose WT(A)=0 as our main assumption, but a few results
based on the assumption WT(A) = Wo will also be reported.3

1 The groups are: wage earner; self-employed in agriculture, forestry and fishing; self-
employed in other industries; and non-employed.
2 This procedure resembles that of Watts (1958, pp. 104-105). He does not, however,
allow for general income growth. Cf. also Somermeyer & Bannink (1973).
8 Neither of these hypotheses can be tested from our data. Our sample indicates that total
net wealth increases up to the age of at least 65 years, depending on the size of the house-
hold. This evidence does not contradict our main assumption. On the basis of observed
wealth of persons aged A today, we cannot predict the wealth of a person who dies at this
age sometime in the future. Furthermore, the systematic underreporting of the values of
wealth in our sample should be kept in mind. This fact seems to favor the hypothesis
WT = 0 rather than WT = WON

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 Consumption function and the life-cycle hypothesis 473

After substituting eqs. (10)-(12) into (8) and adding a stochastic disturbance
e, the consumption function takes the form

C =fl,(A)k(A) +mp(A) YP?mT(A) YT+mw(A) (WO- WT(A)) +6, (13)

where

4,(A) =flo + NN + ? NN 2+ A A + fANAN + AA A2

k(A) =1- T(A)S2 (1 +

and where

m (A)A)1 (D(A+s-1) (1+g )-

MT( ) T(A I
T(A)m

mw(A) = T1A (1 + r)l1T(A) (14)

denotes the MPC of permanent income, transitory income, and wealth, re-
spectively. We note that k(A) is positive, zero, or negative according to whether
the market rate of interest is greater than, equal to, or less than the rate of
growth of minimum consumption (1 + r <.

V. Empirical Results

Estimates of mT and mw, as well as estimates of mp based on the estim

income-age function <D(A) for a wage earner household,' are listed in Table 1.
The planning horizon decreases from about 53 years for a household whose head
is 20 years of age to about 8 years when the age is 75 years. The estimate of
mp is an increasing function of the general rate of income growth, g. It a
increases with an increasing number of houshold members, N. The "average"
estimate (i.e. corresponding to the sample averages of N and A, which are
approximately 3 persons and 50 years, respectively) is 0.82 when no general
income change is assumed (g =0). If income is expected to increase by 3 per
cent annually in all future years up to the planning horizon, the estimate
increases to 1.15. On the other hand, a 3 per cent annual decline in general
income implies an average estimate of 0.62. The estimates of mT and mw
both increasing functions of age, with average values of about 0.04 and 0.02,
respectively.

1 The estimates for households headed by self-employed and non-employed persons deviate
only slightly from those for a wage earner household.

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474 E. Bi0rn

Table 1. Estimates of marginal propensity to consume of permanent income

(mp(A)), transitory income (mT(A)) and wealth (mw(A)); wage earner household

mp(A)

N=3
N=1 N =2 N=4 N=5
A g=O g=0 g= -0.03 g=O g=0.03 g=0 =0 MT(A) mW(A)

20 0.6141 0.6883 0.4292 0.7539 1.5849 0.8217 0.9011 0.0188 0.0052

25 0.6213 0.6902 0.4453 0.7474 1.4551 0.8028 0.8635 0.0206 0.0064
30 0.6330 0.6980 0.4670 0.7488 1.3526 0.7952 0.8432 0.0228 0.0079
35 0.6567 0.7208 0.4978 0.7680 1.3070 0.8090 0.8493 0.0256 0.0100
40 0.6765 0.7375 0.5307 0.7801 1.2352 0.8153 0.8385 0.0291 0.0128
45 0.6969 0.7545 0.5670 0.7925 1.1684 0.8226 0.8497 0.0335 0.0165
50 0.7318 0.7886 0.6153 0.8240 1.1473 0.8508 0.8741 0.0393 0.0215
55 0.7685 0.8235 0.6683 0.8560 1.1261 0.8795 0.8992 0.0469 0.0284
60 0.8015 0.8532 0.7214 0.8819 1.0963 0.9019 0.9180 0.0572 0.0381
65 0.8189 0.8643 0.7627 0.8880 1.0431 0.9037 0.9160 0.0715 0.0519
70 0.8574 0.8993 0.8206 0.9196 1.0353 0.9326 0.9424 0.0917 0.0718
75 0.9447 0.9879 0.9228 1.0074 1.1025 1.0192 1.0279 0.1205 0.1006

A comparison with the corresponding MPC's obtained from ordinary linear

regression is illuminating. We find

C = 15 624 + 0.5679 YP + 0.5849 YT -0.00104W0

(0.0210) (0.0631) (0.00339)

+3 241.1N-180.54A,
(280.0) (25.20)

where the standard errors are given in parentheses below each coefficient. The
standard error of disturbance is 20 431.19. The regression estimate of the MPC
of permanent income is rather low and hardly acceptable as an estimate of
the long-run MPC for use in macroeconomic forecasting. It even falls below
the average estimate of mp in the life-cycle model when the rate of income
growth is set equal to -3 per cent. On the other hand, the MPG of transitory
income is substantially higher. The two MPCs are not significantly different,
according to the regression model. Moreover, the coefficient of net wealth is
negative, although not significantly different from zero. Thus, we can safely
conclude that with reasonable assumptions regarding future income growth,
the life-cycle model gives predictions of the effects of changes in tax and in-
come policies that differ strongly from the predictions provided by a simple
regression model.
Ordinary least squares (OLS) estimates of f,(A), conditional on g and ,i,
are obtained by regression on eq. (13), since the values of mp(A) and k(A) are
known once g and jt are specified.' The result is rather sensitive with respect
1 An intercept term was included in the equation to compensate for possible systematic
errors in our data on consumption and wealth.

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 Consumption function and the life-cycle hypothesis 475

to the value of these parameters, even a one per cent change in ,a may change
the form of the estimated fi1(A) function substantially. In the particular case
of constant minimum consumption and no (expected) growth in general in-
come (y =1.00, g=0.00), we find
est fi1(A) = constant + 14 960.81N -1 020.59N2-213.12A - 181.12AN

(5475.50) (492.68) (1485.44) (104.95)

+ 33.23A2.

(22.32)

A priori, this function could be expected to attain a maximum in an age

interval before retirement. The above result implies that "minimum consump-
tion" is a monotonically increasing function of age when age is greater than
20 years and the number of persons is less than or equal to six. However,
neither of the age coefficients PA or fAA is significantly different from zero at
the 5 per cent level. If, on the other hand, income and minimum consumption
are both assumed to grow at an annual rate of 3 per cent (M ==1.03, g = 0.03),
which is close to the average per capita real income growth in Norway during
the post-war period, we get

est fi1(A) = constant-15 791.86N + 1 331.47N2 + 8 585.78A

(2 1875.56) (2 087.81) (6 329.84)

+ 1 073.79AN - 269.69A2.

(456.95) (99.50)

This estimate of PAA is significantly negative. The valu

fl,1 is rather low, however, about 24 years for a fo
only 20 years for a two-person household.
The goodness of fit, as measured by the estimated standard error of dis-
turbance 6 , is more sensitive with respect to g than with respect to 1u (Table 2).
The estimate increases substantially when g increases from 0 per cent to 4 per
cent, and increases rather slowly with an increasing value of ,u. Thus, restrict-
ing g to be non-negative and ,u to be equal to or exceed unity-a sensible
assumption-we conclude that a specification with constant minimum con.
sumption and no (expected) growth in general income gives the best fit for
our data.

Instead of specifying pu and g a prior, we may regard one or both of them

as unknown parameters to be estimated simultaneously with the fi1(A) func
tion. Using a grid search procedure with a step length of 0.01 across It and
we get the following approximate last squares estimates'

, = 1.04, g = -0.11, AE = 23 530.38.

1 The corresponding estimate of fl,1 is reported in Table 3. Provided that the disturbances
are normally distributed, they are also (approximate) maximum likelihood estimates.

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476 E. Biorn

Table 2. Estimate of the standard error of disturbance 6, conditiona

,u (in Nkr)

9 1.00 1.01 1.02 1.03 1.04

0.00 25 032.56 25 033.59 25 034.60 25 035.60 25 036.54

0.01 25 761.41 25 763.06 25 764.78 25 766.55 25 768.37
0.02 26 835.79 26 837.99 26 840.34 26 842.85 26 845.53
0.03 28 418.39 28 420.93 28 423.69 28 426.71 28 430.44
0.04 30 742.10 30 744.53 30 747.23 30 750.26 30 753.73

A rate of decrease of 11 per cent is hardly a sensible estimate of the expected

income growth of the average Norwegian consumer in 1973.1 In other words,
our cross-section data do not permit reliable inferences to be drawn with
respect to implicit income expectations. Additional information is needed. It is
worth noting, however, that the hypothesis g = 0 is rejected, according to a
1 per cent likelihood ratio test.2 The test statistic (minus two times the natural
logarithm of likelihood ratio) is 405.2, which clearly exceeds the upper 1 per
cent point of the x2 distribution with one degree of freedom, i.e. 6.63. On the
other hand, the hypothesis y = 1 is not rejected; the test statistic is 1.3.
Our analysis so far has been based on an interest rate equal to 2.5 per cent
p.a. and on the hypothesis that all housholds plan with the intention of having
their terminal wealth equal zero. Since the foundation for these assumptions
is not very strong (cf. Section IV), we have reestimated the coefficients with
alternative sets of assumptions to illustrate the sensitivity of the results. The
main results are shown in Table 3. Alternative A is based on an interest rate
of 5.5 per cent. In alternative B, terminal wealth is set equal to its initial value,
i.e. the households are assumed to spend no part of their real and financial
wealth during the planning period. Both of these changes have a substantial
effect on the "age coefficients" PA, PAN, and AA of the minimum consumption
function, but only a moderate effect on the estimates of PN and PNN-parti
ularly for the alternative where Sa is restricted to unity. Recalling the rather
strong connection between (human and nonhuman) wealth and age that is
inherent in the life-cycle hypothesis, this is not surprising. The estimated
standard error of disturbance shows a decrease of about 13 per cent when we
change our assumption with respect to terminal wealth, i.e. our data favor
the hypothesis WT(A) = W0 rather than WT(A) =0.

1 We get the same estimate of g when we restrict minimum consumption by setting it

constant (mu = 1.00). Of course, the low implicit estimate of g may indicate the presence of
specification errors in our model. However, even if actual income growth is positive
negative values of g are not implausible. If a household is risk averse, it may base its
plans on a negative g to protect itself against an unexpected decline in future income.
2 See e.g. Goldfeld & Quandt (1972, p. 74).

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 Consumption function and the life-cycle hypothesis 477

Table 3. Supplementary results; the sensitivity of estimates with respect to a priori

assumptions

a g AiN f9NN PA PAN PAA 1e

I. A prior constraints: y = 1, g = 0
Main variant 1.00 0.00 14 960.81 -1 020.59 -213.12 -181.12 33.23 25 032.56
Alternative Aa 1.00 0.00 11 981.09 -872.83 450.43 - 59.26 6.81 24 214.03
Alternative Bb 1.00 0.00 11 543.81 -1 250.47 1 279.52 -45.95 -9.19 21 896.84
Alternative C' 1.00 0.00 14455.90 -1 178.44 -1 766.32 -122.89 54.95 24296.52

II. A prior constraint: ,y = 1

Main variant 1.00 -0.11 15 448.40 -2 437.10 -69.52 357.89 33.53 23 535.44
Alternative Bb 1.00 -0.08 13 054.07 -2 402.53 1 899.14 380.07 -16.16 20 506.20
Alternative CC 1.00 -0.08 17 359.90 -2 484.64 -813.67 292.26 44.35 23 328.58

III. /2 and g free parameters

Main variant 1.04 -0.11 -10 839.45 2 858.10 1 958.09 -591.99 -85.89 23 530.38
Alternative Bb 1.05 - 0.08 -3 680.94 1 510.39 -73.57 -351.84 -14.68 20 500.77
Alternative CC 1.05 -0.08 -6 088.40 1 567.52 1 738.52 -301.18 -58.82 23 322.97

a r = 0.055 instead of r = 0.025.

b WT(A) = Wo instead of WT(A) = 0.
C Households headed by self-employed persons deleted from sample.

An objection frequently raised against the strict version of the life-cycle

hypothesis is that the actual planning horizon of the average consumer is
probably far shorter than his expected remaining lifetime; it may be as short
as 2-3 years. We have reestimated the model with a planning horizon of T = 3

years for all households, regardless of age, and with r = 0.025, Iu = 1.00, and
g = 0.00. The resulting (average) estimates of the MPCs are

mP =0.97,

mT = 0.33,

mw =0.32.

However, this model gives a poorer fit for our data than the strict life-cycle
model with T specified as a decreasing function of age, eq. (9). The estimated
standard errors of disturbances are

6d = 42 747.07 when WT =O

6 = 22 193.81 when WT = WON

In the life-cycle model, the corresponding estimates were 25032.56 and

21 896.84, respectively.
Finally, it is often asserted that the consumption behavior of households

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478 E. Bi0rn

headed by self-employed persons (i.e. households in which entrepreneurial in-

come dominates) differs strongly from that of wage earner households; the
narrow hypothesis of maximization of the utility of consumption is inadequate.
To some extent, this suspicion is supported by our data. Omitting all house-
holds headed by self-employed persons from the sample' (alternative C), the
estimates of the fly's change significantly. Again, the "age coefficients" PA,
and PAA turn out to be the most sensitive, suggesting that households headed
by self-employed persons exhibit atypical bequest behavior and a particular
wealth accumulation structure. The standard error of disturbance, however,
is only about 2 per cent lower than in the main variant.

VI. Concluding Remarks

In this paper, we have been concerned with estimating consumption functions

from cross-section data on consumption expenditure, income (by source) and
net wealth. Our model, based on a life-cycle theory with a utility function of
the Stone-Geary form, has four obvious virtues. First, it reflects the fact that
young persons usually have longer planning periods than older people, thereby
incorporating the effect of age and wealth on consumption in a systematic
way. Second, it distinguishes between permanent and transitory income.
Third, it takes into account the role of the interest rate in determining the
allocation of consumption and saving over time. The model implies, inter alia,
that the MPCs of permanent income and wealth are both decreasing functions
of the rate of interest. Fourth, the resulting consumption function is linear
in income and wealth-an obvious virtue when it comes to aggregation.
The estimate of the MPC of permanent income is generally high and in-
creasing with an increasing number of household members. It is also an in-
creasing function of the (expected) rate of general income growth. If no growth
is assumed, i.e. only the age-specific component in the income path is allowed
for, the average estimate is about 0.82. This is well above the corresponding
estimate when using a simple regression model on the same data. If positive
general income growth is assumed, the estimate may even exceed unity. On
the other hand, the average estimate of the MPC of transitory income is as
low as 0.04. The effect of the age of the head of household on the minimum
consumption parameter in the utility function is not precisely determined by
our estimates. These estimates are also rather sensitive with respect to the
value specified for the general rate of income growth, the interest rate and
terminal wealth. Our data do not permit a meaningful estimation of the im-
plicit rate of consumers' expected income growth.
The construction of an aggregate consumption function from the estimated
micro function (13) with appropriate choice of the values of the growth para-

1 466 of the 3 271 households in the sample were headed by self-employed persons.

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 Consumption function and the life-cycle hypothesis 479

meters Iu and g is, in principle, fairly straightforward. Since all the MPCs
are age-dependent and the MPC of YP also depends on N, information on
the simultaneous distribution of Yp, A and N, the distribution of yT and A,
as well as the distribution of WO and A would be needed in order to achieve
a formal aggregation.' These distributions are likely to change rather slowly
over time-the distribution of yT and A constitutes a possible exception. As a
first approximation, the distributions as observed in our 1973 sample might
be used. Reestimation of the aggregate MPCs would be required if either the
income, age and wealth distributions or the long-term rate of interest show
perceptible changes. The MPC of permanent income should also be reestimated
when the general outlook with respect to the future growth of household
income changes significantly.
The model has obvious deficiencies; the most serious ones are probably
those which follow from its main simplifying assumption of a perfect credit
market and its disregard of uncertainty with respect to future income and
remaining lifetime. However, these assumptions may be more appropriate on
the macro level than they are for individual households. The model also
ignores the fact that expectations of future increases in the relative prices of
real capital, notably dwellings, may be a decisive factor in explaining saving
and bequest behavior. These problems certainly deserve further research. Some
of the shortcomings of our analysis, of course, reflect inadequacies of our data,
in particular the fact that the sample covers only one year and that it does
not contain any information on the expected future income of the households
observed. If complete time-series data (longitudinal data) were at hand, a
possible extension might be to introduce some kind of "habit formation", by
letting minimum consumption fi, depend in some way on lagged consumption
expenditure. This might eliminate some of the problems related to the "flat-
ness" of the likelihood function and the subsequent difficulties in obtaining
precise estimates of the age parameters in the minimum consumption function.
We conclude by citing James Tobin:

If household surveys are to contribute further to our understanding of the pro-

pensity to consume and make possible more powerful tests of competing theories,
they will have to take a longer perspective. To measure the effects of past and
expected levels of income and wealth and of retirement and bequest objectives,
it is necessary to observe not only the current status of households but their life-
time histories, plans, and aspirations. [Tobin (1975, p. 86).]

1 This procedure-estimation before aggregation-is, in a sense, the opposite of that

used by Ando & Modigliani (1963), who aggregate before estimating the consumption
function.

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480 E. Bi0rn
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