The Euler Equation Approach: Critical Implications of Recent Developments in the Theory of Intertemporal Choice

The paper deals with the development of the mainstream theory of intertemporal choice based on the idea that individuals choose consumption and saving in order to maximize lifetime expected utility subject to an intertemporal budget constraint. This analytical framework rests on the theories developed in the 1950s by Modigliani and Friedman and revisited in the 1970s with the introduction of the rational expectations assumption. Starting with Hall (1978), the literature focused on testing the model relying on the first order conditions of the optimization problem faced by the consumer — the Euler equation — and a number of empirical puzzles arose. Therefore, the subsequent decades were dedicated to progressively modifying the original model so as to render it able to explain the data. The paper argues that the introduction of highly specific assumptions, needed to reconcile theory and empirical evidence, has affected the generality of the implications that can be drawn from the model. Furthermore, the ever more substantial departure from the original formulation seems to have resulted in a gradual abandonment of the very premises on which the neoclassical approach to consumption analysis was built.