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Recent empirical work on consumption has focused on the adequacy of the permanent income hypothesis, as characterized by the `random walk' model proposed by Robert Hall in 1978. Two strands of research can be identified in this literature. One strand of research has focused on further describing, extending, and testing the degree to which consumption corresponds to the optimizing model. Another strand of the literature has focused attention on assessing the degree to which consumption deviates from the predictions of the permanent income hypothesis. In Discussion paper No. 1289, Research Associate Tamim Bayoumi combines elements of both literatures. A new specification for testing the relative importance of the path implied by full insurance and by sensitivity to current income is derived. The specification is tested using data on consumption across Canadian provinces. The focus of the estimation is less on whether or not the full insurance model can be rejected than on how much each of these hypotheses can contribute to explaining overall variation in consumption. Both types of behaviour are found to be statistically significant, but the full insurance model is found to explain considerably more of the growth in consumption than changes in income do. Explaining Consumption: |