Research in Economics (2002) 56, 3–59 doi:10.1006/reec.2001.0268 Available online at http://www.idealibrary.com on Dynamic factor models of consumption, hours and income JOSEPH G. ALTONJI † ,ANA PAULA MARTINS ‡ AND ALOYSIUS SIOW § † Northwestern University, Evanston, IL 60208, U.S.A. ‡ Universidade Cat´ olica Portuguesa, 1600 Lisboa, Portugal § University of Toronto, Toronto, ON, Canada (Received 28 February 1998, accepted 4 August 2001) Summary This paper addresses two questions in the economics of intertem- poral choice. First, what are the key factors that drive fluctuations in income and what are the time paths of their effects? Second, how do consumers respond to these factors? We answer these questions by estimating dynamic factor models of consump- tion, hours, wages, unemployment, and income that account for measurement error and the fact that variables used in the study are measured at different time intervals and/or are aggre- gates for the calendar year. We pay special attention to a dynamic factor representation of a joint life cycle model of consumption and labour supply, which permits us to quantify the effect of wages, unemployment, and other factors on the marginal utility of income as well as to estimate the substitu- tion effects of wage changes on labour supply and consumption.  2002 University of Venice An initial draft of this paper was presented at the Econometric Society Meetings in New York, December 1985. We wish to thank Jonathan Friedman and Thomas Melito for excellent research assistance. We also thank John Ham, V. Joseph Hotz, John Kennan, Steven Zeldes, two anonymous referees, and participants in seminars at University of Chicago, McMaster University, Princeton University, University of Toronto, University of Virginia, and Yale University for valuable comments. We are also grateful for Guglielmo Weber for encouraging us to revive the paper and for helpful suggestions. This research was supported by the National Science Foundation under grant SES-8513470. 1090–9443/02/010003 C 57 $35.00/0  2002 University of Venice