Expected Consumption Growth Research Articles

Expected Consumption Growth from Cross-Country Surveys: Implications for Assessing International Capital Markets

Survey data show that the expected growth rates of consumption across countries vary widely and are not highly correlated. This data contradicts the simplest of open-economy models in which there is a freely traded non- state-contingent bond and purchasing power parity holds. We explore two alternative explanations for the finding: that households in each country in effect face different ex ante real interest rates or that there are significant credit constraints, so that expected consumption growth rates are driven largely by expected income growth. The empirical evidence strongly supports the latter hypothesis. These findings challenge the modeling of consumption that is at the heart of many, if not most, macroeconomic models.

Long Run Risks in the Term Structure of Interest Rates: Estimation

Using Bayesian methods, this paper estimates a model in which persistent fluctuations in expected consumption growth, expected inflation, and their timevarying volatility determine asset price variation. The analysis of the U.S. nominal term structure data from 1953 to 2006 shows that i) agents dislike high uncertainty and demand compensation for volatility risks, ii) the time variation of the term premium is driven by the compensation for fluctuating inflation volatility, and iii) estimates of risk factors are broadly consistent with survey data evidence. JEL Classification: C32, E43, G12

Expected Consumption Growth from Cross-Country Surveys: Implications for Assessing International Capital Markets

Survey data show that the expected growth rates of consumption across countries vary widely and are not highly correlated. This data contradicts the simplest of open-economy models in which there is a freely traded non- state-contingent bond and purchasing power parity holds. We explore two alternative explanations for the finding: that households in each country in effect face different ex ante real interest rates or that there are significant credit constraints, so that expected consumption growth rates are driven largely by expected income growth. The empirical evidence strongly supports the latter hypothesis. These findings challenge the modeling of consumption that is at the heart of many, if not most, macroeconomic models.

Long-Run Risk Through Consumption Smoothing

We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein-Zin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent time-variation in expected consumption growth (long-run risk). This increases the price of risk when investors prefer early resolution of uncertainty, and the model can then account for the low volatility of consumption growth and the high price of risk with a low coefficient of relative risk aversion. The asset price implications of endogenous long-run risk depends crucially on the persistence of technology shocks and investors preference for the timing of resolution of uncertainty. We use the time-series of consumption growth and the cross-section of stock returns to evaluate different parameterizations of the model.

International Risk-Taking, Volatility, and Consumption Growth

We show that countries that take on more international risk are rewarded with higher expected consumption growth. International risk is defined as the beta of a country’s consumption growth with world consumption growth. High‐beta countries hold more foreign assets, as predicted by the theory. Despite the positive effects of beta, a country’s idiosyncratic volatility is negatively correlated with expected consumption growth. Therefore, uninsured shocks affect not only current growth, but also future consumption growth. High‐volatility countries have worse net foreign asset positions, suggesting that solvency constraints limit their future growth.

Asset pricing with unforeseen contingencies

We investigate an economy of heterogeneous agents that cannot specify all exogenous welfare-relevant events and consequently view the impact of unforeseen contingencies as utility shocks. In this setting we characterize an appropriate market equilibrium concept when securities can trade only on demand- and price-contingent events. We establish the existence of an equilibrium for a class of parametric models in which aggregating taste shocks across agents can lead to nonconsumption pricing factors. To fit the stylized facts, (i) non consumption factors must dominate the pricing kernel and contribute to the variation of the wealth-consumption ratio, (ii) markets must be incomplete and the set of claims that are traded endogenously determined, (iii) agents’ preferences with respect to unforeseen contingencies must be non-expected utility, and, (iv) although non-consumption pricing factors can be conditionally uncorrelated with aggregate consumption shocks, they must be correlated with shocks to expected consumption growth.

Consumption, Dividends, and the Cross-Section of Equity Returns

A central economic idea is that an asset's risk premium is determined by its ability to insure against fluctuations in consumption (i.e., by the consumption beta). Cross-sectional differences in consumption betas mirror differences in the exposure of the asset's dividends to aggregate consumption, an implication of many general equilibrium models. Hence, cross-sectional differences in the exposure of dividends to consumption may provide valuable information regarding the cross-sectional dispersion in risk premia. We measure the exposure of dividends to consumption (labeled as consumption leverage) by the covariance of ex-post dividend growth rates with the expected consumption growth rate, and alternatively by relying on stochastic cointegration between dividends and consumption. Cross-sectional differences in this consumption leverage parameter can explain about 50% of the variation in risk premia across 30 portfolios - which include 10 momentum, 10 size, and 10 book-to-market sorted portfolios. The consumption leverage model can justify much of the observed value, momentum, and size risk premium spreads. For this asset menu, alternative models proposed in the literature (including time varying beta models) have considerable difficulty in justifying the cross-sectional dispersion in the risk premia. Our measures of consumption leverage are driven by the exposure of dividend growth rates to low frequency movements in consumption growth. We document that it is this exposure that contains valuable information regarding the cross-sectional differences in risk premia across assets.

The Term Structure of Interest Rates and Expected Economic Growth

Many papers have documented the positive relationship between the slope of the yield curve and future real economic activity in different countries and different time periods. One explanation for this economic link is based on monetary policy. However, empirical evidence (Estrella and Hardouvelis, 1991; Plosser and Rouwenhorst, 1994; Estrella and Mishkin, 1997; Moersch, 1996a,b; Kozicki, 1997; Dotsey, 1998; Ivanova et al., 2000) has shown that monetary policy does not appear to be the only source of the predictive power of the term spread. Therefore, the spread reflects other economic conditions beyond actions taken by monetary authorities. According to Harvey (1988), the forecasting ability of the term spread on economic growth is due to the fact that interest rates reflect the expectations of investors about the future economic situation when deciding about their plans for consumption and investment. Harvey (1988) uses the Consumption-Based Asset Pricing Model (CCAPM) to derive a forecasting equation that relates the slope of the term structure of interest rates to expected consumption growth. Harvey's model has been tested in several countries using ex post consumption or output growth as proxies of expected consumption growth. This paper complements and extends the evidence of Harvey's model by testing it for the case of Spain and by using a measure of expected consumption growth rather than proxies for the investors' expectations. The variables used are the Consumer Confidence Indicator and the Economic Sentiment Indicator (elaborated by the European Commission) that directly stand for the expectations of economic agents about the future economic situation in the next twelve months.

The Real Term Structure and Consumption Growth

One version of the consumption-based asset pricing model implies a linear relation between expected returns and expected consumption growth. This paper provides evidence that the expected real term structure contains information that can be used to forecast consumption growth. The evidence is strongest for the 1970's and 1980's. The real term structure contains more information than two alternative measures: lagged consumption growth and lagged stock returns. Further, the real term structure appears to have slightly more forecasting power than the leading commercial econometric models. This is the working paper version of my 1988 Journal of Financial Economics article.

Precautionary Saving and Consumption Fluctuations

This paper uses the consumption Euler equation to derive a decomposition of consumption growth into four sources. These are new information and three sources of predictable consumption growth: intertemporal substitution, changes in the preferences for consumption, and incomplete markets for consumption insurance. Using data on the expenditures of households, we implement the decomposition for the average growth rate of consumption expenditures on nondurable goods in the U.S. from the beginning of 1982 to the end of 1997. Incomplete markets for trading consumption in future states lead to statistically significant and countercyclical movements in expected consumption growth: consumption growth is expected to be higher when the unemployment rate is high. The economic importance of precautionary saving rivals that of the real interest rate, but the relative importance of each source of movement in the volatility of consumption is not precisely measured.

What Do Aggregate Consumption Euler Equations Say About the Capital-Income Tax Burden?

Aggregate consumption Euler equations fit financial asset return data poorly. But they fit the return on the capital stock well, which leads us to three empirical findings relating to the capital income tax burden. First, capital taxation drives a wedge between consumption growth and the expected pre-tax capital return. Second, capital taxation is the major distortion in the capital market, in the sense that most of the medium and long run deviations between expected consumption growth and the expected pre-tax capital return are associated with capital taxation. Third, consumption growth appears to be pretty elastic to the after-tax capital return (i.e., capital is elastically supplied), even while it appears inelastic to returns on various financial assets. Capital income taxes are passed on through reduced capital accumulation, or higher markups, or some combination.

Stochastic growth: a duality approach

We re-examine the representative agent's optimal consumption and savings under uncertainty in the presence of investment constraints using martingale representation and convex analysis techniques. This framework allows us to explicitly quantify precautionary savings which induces a higher average growth rate than in a certainty setup. We provide a closed form solution for a Cobb–Douglas economy. The effect of uncertainty on portfolio selection is analyzed. Consumption growth rate and risk free interest rate exhibit a U-shaped relationship. Uncertainty negatively affects expected consumption growth rate; such a result seems to be supported by empirical evidence.

Approximation Bias in Linearized Euler Equations

A wide range of empirical applications rely on linear approximations to dynamic Euler equations. Among the most notable of these is the large and growing literature on precautionary saving that examines how consumption growth and saving behavior are affected by uncertainty and prudence. Linear approximations to Euler equations imply a linear relationship between expected consumption growth and uncertainty in consumption growth, with a slope coefficient that is a function of the coefficient of relative prudence. This literature has produced puzzling results: estimates of the coefficient of relative prudence (and the coefficient of relative risk aversion) from linear regressions of consumption growth on uncertainty in consumption growth imply estimates of prudence and risk aversion that are unrealistically low. Using numerical solutions to a fairly standard intertemporal optimization problem, our results show that the actual relationship between expected consumption growth and uncertainty in consumption growth differs substantially from the relationship implied by a linear approximation. We also present Monte Carlo evidence that shows that the instrumental-variables methods that are commonly used to estimate the parameters correct some, but not all, of the approximation bias.

The cyclical properties of consumption growth and the real term structure

Expected real yields on nominally risk-free bonds and expected consumption growth at horizons from one-quarter to two years are identified using time series models, and their basic properties are examined. The principal results are: (1) real yields and consumption growth are (weakly) negatively correlated over the full sample period of 1953–1991; (2) excluding the 1979–1985 sub-period, real yields and consumption growth are (strongly) positively correlated; (3) the cyclical properties of real yields and consumption growth are qualitatively similar in the pre-1979 data, and they are consistent with a simple real business cycle model.

The Intertemporal Elasticity of Substitution: An Exploration using a US Panel of State Data

This paper uses state-level consumption data to estimate the intertemporal elasticity of substitution of consumption (IES). In contrast to the results of Hall (1988) and Campbell and Mankiw (1989), we provide evidence indicating that the IES is significantly different from zero and probably close to one. Since inference about the IES in the context of the standard Euler equation is problematic as a result of mis-specification bias, we cast most of our discussion in the context of the framework developed by Campbell and Mankiw. This modifies the Euler equation in that a fraction of agents simply consume their income. The use of panel data to examine the relationship between interest rates and consumption growth has two advantages. First, we achieve a significant increase in precision, which in particular allows us to rule out a zero IES. Second, we can use the panel aspect of the data to bypass asset return measurement problems. In particular, we identify a common time component in expected consumption growth that is associated with movements in interest rates when the IES is positive.

The real term structure and consumption growth

One version of the consumption-based asset pricing model implies a linear relation between expected returns and expected consumption growth. This paper provides evidence that the expected real term structure contains information that can be used to forecast consumption growth. The evidence is strongest for the 1970s and 1980s. The real term structure contains more information than two alternative measures: lagged consumption growth and lagged stock returns. Further, the real term structure appears to have slightly more forecasting power than the leading commercial econemetric models.