Consumption, Wealth, and Indebtedness in the Context of Uncertainty : The Consumption Function Meets Portfolio Theory

Abstract

The ojective of this paper is to provide a sound theoretical framework for the empirical analysis of consumer indetedness, by integrating Portfolio theory with the Life-Cycle Hypothesis (LCH) model of consumption. Modern versions of this LCH theory almost always assume that utility is additive over time, but this study, the multiplicative Cobb-Douglas function is used. The new sythesis also explains the stochastic properities of consumption more fully and clearly than previous studies, in particular the uncerttainty arising from the rates of return on risky assets. The new theory will also help to improve the explanation of the surprise changes in consumption because these sources of risk are incorporated explicitly into the analysis.