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Inequality and the Current Account

Most economists think about aggregate consumption through the lens of Friedman’s permanent income hypothesis or Modigliani’s life-cycle hypothesis. But long ago there was a third contender, Duesenberry’s relative income hypothesis, which argued that household consumption decisions are powerfully shaped by the behavior of their reference group.

Institute for New Economic Thinking grantees Christian Belabed and Thomas Theobald and their co-authors have revived this old theory as a hypothesis to explain the apparent statistical link between rising income inequality and current account deficits. The middle class, so the argument goes, is just trying to keep up with the consumption norms of the upper class, which keep expanding as more aggregate income flows upward.

Duesenberry’s hypothesis arose from a melding of ideas from social psychology with ideas from economics. Revising his hypothesis is one way to bring economics back into contact with psychology and help the discipline get closer to understanding realistic conceptions of human behavior. That’s new economic thinking.

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