Estimating the elasticity of intertemporal substitution: Is the aggregate financial return free from the weak instrument problem? (original) (raw)
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Economics Bulletin, 2015
Since the 1980s, researchers have been puzzled by close to zero estimates of the elasticity of intertemporal substitution. Two possible causes are rates of return that are not representative of the agent's portfolio return and inconsistent estimates due to the weak instrument problem. We examine if the aggregate capital return series for the United States and several instrument sets can provide large estimates of this elasticity. Our findings indicate that this return series leads to large estimates of the elasticity using different instrument sets. An unusual set of instruments performed well and its use in consumption-model estimates seems promising.
Consumption, Wealth, the Elasticity of Intertemporal Substitution and Long-Run Stock Market Returns
SSRN Electronic Journal, 2005
The elasticity of intertemporal substitution is a parameter of crucial importance for macroeconomic policy. The available macroeconomic evidence on the value of this parameter for the US is conflicting. Calibrated dynamic models require a value close to one of the EIS to match the data, while estimated Euler equations concentrating on high frequency fluctuations in consumption deliver much lower values not significantly different from zero. Some recent empirical evidence indicates that the well-known asset pricing puzzles might be solved by considering consumption in the long-run. We extend these results to obtain an empirical estimate of the EIS consistent with that used in calibrated models.
The Elasticity of Intertemporal Substitution Reconsidered
2014
The elasticity of intertemporal substitution is a crucial parameter in …nance and macroeconomics, yet its estimation remains elusive. We show, based on Fisher's relation and the expectations theory of the term structure, that the EIS is the inverse of the product of the average term to maturity of debt instruments and the consumption-output ratio. Therefore, the EIS need not be estimated but can be calibrated from observable data.
2004
This paper develops a simple but general methodology to estimate the expected intertemporal marginal rate of substitution or "EMRS", using only data on asset prices and returns. Our empirical strategy is general, and allows the EMRS to vary arbitrarily over time. A novel feature of our technique is that it relies upon exploiting idiosyncratic risk, since theory dictates that idiosyncratic shocks earn the EMRS. We apply our methodology to two different data sets: monthly data from 1994 through 2003, and daily data for 2003. Both data sets include assets from three different
Consumption adjustment to real interest rates: Intertemporal substitution revisited
Journal of Economic Dynamics and Control, 1998
This paper investigates the degree of elasticity of intertemporal substitution in consumption using postwar US aggregate data. Previous findings suggest that the elasticity of substitution is unlikely to be much above 0.1 and may well be zero. In contrast, I find strong evidence that there is a statistically significant positive response of consumption growth to changes in expected real interest rates. The elasticity estimates cluster around 0.3. Previous weak results are attributed to either the inappropriate choice of instruments or the use of an inadequate measure of consumption. This finding is robust to considerations of the time aggregation bias, different sample periods, and alternative formulations of the permanent income consumption model which include 'rule-of-sum' consumers and borrowing constraints. For example, if the Campbell and Mankiw model is adopted as an approximate description of US aggregate time series in consumption, income and real interest rates, the implied elasticity of intertemporal substitution for permanent income consumers could be as high as 0.8, which implies that the coefficient of relative risk aversion is around 1.25.
Estimating the expected marginal rate of substitution: Exploiting idiosyncratic risk
2004
ABSTRACT This paper develops a simple but general methodology to estimate the expected intertemporal marginal rate of substitution or" EMRS", using only data on asset prices and returns. Our empirical strategy is general, and allows the EMRS to vary arbitrarily over time. A novel feature of our technique is that it relies upon exploiting idiosyncratic risk, since theory dictates that idiosyncratic shocks earn the EMRS.
A FINANCE APPROACH TO ESTIMATING CONSUMPTION PARAMETERS
Economic Inquiry, 2011
This paper relates consumption economics more closely to an aggregate financial variable than in any previous research. We compile the net real rate of return on a synthetic mutual fund (SMF) encompassing all major classes of financial assets and residential real estate. Return on the SMF better represents the market return of financial portfolio theory than any measure in use today and we demonstrate its merit in an expected utility model to estimate consumption parameters, the coefficient of relative risk aversion (CRRA), and intertemporal elasticity of substitution (IES). The estimates are stable across varying time periods and alternative measures of consumption. (JEL E21, D91, G11, C13)
2005
This paper investigates the impact of the inclusion of housing in a household portfolio on household's intertemporal decision making. Residential housing is one of the principal assets households hold, and thus changes in housing return can affect household consumption over time. We assess whether the inclusion of housing in the household portfolio affects one of the important parameters of the intertemporal choice, the intertemporal elasticity of substitution (IES). The IES measures how a change in asset return affects household's consumption growth. Since the use of aggregate time series data presents potential aggregation problems, we estimate a consumer model using household-level data, in particular the Consumer Expenditure Survey (CEX), and thus account for household heterogeneity and demographics. Moreover, utilizing a household-level data set, we estimate IES parameters for different groups of assetholders: stockholders, bondholders, and homeowners. Our results indicate that a higher housing return positively affects consumption growth, and housing is an important asset to account for in the household portfolio. The estimation with the portfolio return that includes housing results in the IES of about 0.3, which is lower than that obtained using the Treasury bill rate. The estimation is also more robust to alternative sets of instruments and for different groups of assetholders.
Time-Varying Returns, Intertemporal Substitution and Cyclical Variation in Consumption
2011
This paper studies the importance of intertemporal substitution in consumption for the cyclical co-movement of consumption, net worth and income. We can largely explain the empirical hump-shaped consumption response to a transitory wealth increase by allowing for time-varying returns in an otherwise standard Permanent Income Hypothesis (PIH) model. At the net worth peak, households bring consumption forward in anticipation of low returns on saving. The PIH model fully explains the empirical response when households initially expect the net worth shock to be permanent, but gradually learn that it is in fact transitory.