Abstract
“The buffer stock theory” derived from the intertemporal utility maximization predicts that an increase in wealth will dampen the motive for precautionary savings and therefore reduce consumption’s over-sensitivity with respect to income changes. Since over the last forty years Taiwan has more than once experienced sharp rises in the values of the stock market and real estate, the goal of this paper is to examine whether the prediction of the buffer stock theory holds in Taiwan. The empirical model we propose is a trivariate two- state Markov regime-switching model originating from the Euler equation for consumption growth. The three macro variables we consider are the real non-durable goods consumption growth, the real GDP growth, and the real growth in the stock market’s total value. It is assumed that these three variables are subject to the same Markov regime-switching variable in determining their two states. Our empirical results using Taiwan‘s quarterly data suggest a high growth state and a low growth one: the former includes 1973Q3, 1973Q4, 1978Q3, .1987Q2-1990Q1, 1991Q2, and 1991Q3. The main finding of this paper is as follows: It is indeed the precautionary savings motive that causes the aggregate consumption in Taiwan to be overly sensitive to income changes, just as the buffer stock theory has predicted. When wealth in Taiwan, symbolized by the values of stock market, increased substantially under the high growth state, consumers’ precautionary savings motive weakened and the over-sensitivity phenomenon to a large extent disappeared.