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Consumption dynamics with law of small numbers

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  • Niu, Yingjie
  • Wu, Yaoyao
  • Zhao, Siqi
  • Zou, Zhentao

Abstract

We propose an intertemporal consumption-saving model by exploring the implications of the Law of Small Numbers (LSN), a belief heuristic stating that any sample realization of a population should be representative of the population. First, the existence of the LSN reduces the precautionary savings demand. More importantly, we show that the LSN belief structure provides an alternative explanation for two fundamental anomalies in consumption theory: (1) excess sensitivity by showing that past changes in income predict future changes in consumption; and (2) excess smoothness by lowering consumption volatility and generating the empirical magnitude.

Suggested Citation

  • Niu, Yingjie & Wu, Yaoyao & Zhao, Siqi & Zou, Zhentao, 2024. "Consumption dynamics with law of small numbers," Journal of Economic Behavior & Organization, Elsevier, vol. 224(C), pages 915-923.
    • Handle: RePEc:eee:jeborg:v:224:y:2024:i:c:p:915-923
    DOI: 10.1016/j.jebo.2024.06.021
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    More about this item

    Keywords

    Law of small numbers; Consumption; Excess sensitivity; Excess smoothness;
    All these keywords.

    JEL classification:

    • B49 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Other
    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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