What Explains the Consumption Decisions of Low-Income Households?

Abstract

A variety of distortions, such as financial constraints and behavioral biases, have been proposed to explain deviations from canonical consumption-savings models. We develop a new sufficient statistics approach to measure the impact of such distortions on consumption as a wedge between actual consumption and a counterfactual ”frictionless” consumption. We calculate these wedges for a population of predominantly low-income US consumers using a new survey of economic beliefs linked to bank account transactions data. We find that consumption choices are significantly distorted both upwards and downwards. The median wedge is 40% of frictionless consumption in absolute value, with 51% having negative wedges (underconsuming) and 49% having positive wedges (over-consuming). Because alternative models of distortions imply different properties of wedges, estimates of wedges can be used as a diagnostic to distinguish between models. Notably, financial constraints only generate negative wedges, indicating that additional or alternative distortions (such as present bias or consumer inertia) are necessary to rationalize the consumption decisions of low-income households.