Intertemporal Substitution In Consumption Research Articles

Durable goods and consumer behavior with liquidity constraints

AbstractThis paper presents an integrated model of intratemporal demand and intertemporal consumption, with allowance for durable goods and liquidity constraints. Demand equations for non‐durable and durable goods with the user cost of durable goods are jointly estimated with a consumption Euler equation incorporating liquidity constraints for Norwegian consumers from 1978 to 2018. Results show that demand analyses ignoring durable goods lead to a significant bias in the elasticities of non‐durable goods. Norwegian consumers are found to be impatient, with low risk aversion. There is weak evidence for liquidity constraints in consumption. No strong evidence exists for intertemporal substitution in consumption, but a considerable effect of uncertainty is found in durable consumption.

Weak Instruments, Degree of Risk Aversion and Equity Premium: Evidence from Singapore, South Korea and Taiwan

AbstractUsing data from Singapore, South Korea, and Taiwan, we estimate the coefficient of relative risk aversion (RRA) in the constant relative risk aversion utility specification of the consumption‐based capital asset pricing model. Conventional instrumental variables methods find that the coefficient of RRA is low but the inverse of it—the elasticity of intertemporal substitution in consumption—is also low. Such contradictory findings could be attributed to instruments being weak. Using weak‐instrument robust tests, we find from the equity market data that the coefficient of RRA is rather high, which could potentially explain the high equity premiums in these three East Asian economies.

Human capital, innovation, and growth

AbstractThis paper explores the interaction between human capital and innovation in the process of economic growth. Using a model of endogenous growth, we focus on how taxes and other policy instruments affect the incentives to invest in human capital. In contrast to many other growth models we find that the taxation of human capital has a substantial negative effect on its accumulation. This in turn reduces innovation and, consequently, the income growth rate. More surprisingly, other policies that are intended to stimulate growth may have opposing effects on innovation and the accumulation of human capital. For example, while subsidies to research and to intermediate inputs do have positive effects on innovation and growth, they lead to a lower stock of human capital, in the empirically relevant case when the elasticity of intertemporal substitution in consumption is low.

Robust consumption and portfolio choice with derivatives trading

This paper analyzes the optimal consumption and portfolio choice problem for an ambiguity-averse investor with recursive preferences. The investor has access to both the stock and derivatives markets. The stock price process follows a stochastic volatility jump-diffusion model and the investor can have different levels of ambiguity about diffusion and jump risks, respectively. We obtain an exact analytical solution for investors with unit elasticity of intertemporal substitution of consumption and an approximate solution otherwise. We find that the optimal consumption policy is more sensitive to ambiguity aversion with respect to diffusion risks than the jump risk. The optimal exposures to diffusion and jump risks are significantly affected by the corresponding ambiguity aversions in the complete market; however, the optimal stock investment is relatively insensitive to jump misspecification in the incomplete market. We also show that taking into consideration ambiguity aversion to diffusion risks and participating in the derivatives market are essential to reduce the potential welfare loss, while the impact of jump misspecification is marginal.

Trend Shocks, Liquidity Constraints and China’s Economic Fluctuations

The development of China’s economy not only contains the commonalities of all countries in the world, which can be explained by existing theories to a large extent, but also presents many development characteristics that are different from other countries, which needs to be explored from a new perspective. Analyzing the data on output, consumption, and investment in the 40 years after the reform and opening up from 1978 to 2018, we can find the following characteristics: (1) The economy of China is more volatile than those of developed countries, and consumption volatility is greater than that of output, a phenomenon in sharp contrast with the rational consumption behavior obtained from the permanent income hypothesis. (2) Since 1978, China’s economic volatility has shown a downward trend, and consumption volatility has declined even faster than that of output. (3) Since 2008, China’s economic growth rate has continued to decline.The academic circles attribute the miracle of China’s economic development to a series of institutional reforms since the reform and opening up. However, what has been ignored by the academic circles is that since the institutional reforms are the main driver of China’s rapid economic growth in the past 40 years, as a logical corollary, they must also be an important factor that leads to sometimes rapid and sometimes slow performance of China’s economic growth and the formation of several development cycles. Different from the deviation from trend caused by various random shocks, such as government purchases, money and information, and financial and non-financial frictions, a series of institutional reforms such as the transformation from a planned economy to a market one, the development of private enterprises from illegal to mushrooming, and China’s entry into the World Trade Organization impact the trend itself, changing and supporting China’s rapid economic growth, intertwining its trend fluctuations with cyclical fluctuations.In order to illustrate the above characteristics, this paper constructs a dynamic stochastic general equilibrium model of small open economies with persistent trend shocks and liquidity constraints. The research results show that: First, after the reform and opening up, a series of institutional changes are an important cause for China’s economic fluctuations to be greater than that of developed countries. Second, there is an obvious random trend in China’s economy. Large fluctuations in output, especially in consumption, are caused by both trend shocks and cyclical shocks. Third, these two shocks are not enough to explain large fluctuations in consumption, especially the fact that consumption fluctuations are greater than that of output, but their combination with liquidity constraints explains this feature pretty well. The introduction of trend shocks increases consumption volatility through the permanent income hypothesis, while the introduction of liquidity constraint increases consumption volatility by reducing the inter-temporal substitution of consumption. Fourth, through comparative analysis of the changes in the driving factors of economic fluctuations in the two stages from 1978 to 1999 and from 2000 to 2018, it is found that with the gradual improvement of the market economic system, both the cyclical shock that has a temporary impact and the trend shock that has a persistent impact on economic fluctuations show a gradual attenuation trend, reducing China’s economic volatility. As the impact of trend shocks declines faster, cyclical shocks gradually play a dominant role in China’s economic fluctuations.

Asset bubble and endogenous labor supply: A clarification

This paper analyzes the link between asset bubbles, endogenous labor and capital. First, we explicitly and theoretically derive the conditions to have a crowding-in effect of the bubble, i.e. higher levels of capital and labor. Second, the utility function we consider shows that this result does not require an arbitrarily high elasticity of intertemporal substitution in consumption.

Quasi-Hyperbolic Discounting under Recursive Utility and Consumption-Investment Decisions

This paper examines an Epstein-Zin recursive utility with quasi-hyperbolic discounting in continuous time. I directly define the utility process and consider a Merton's optimal consumption-investment problem for application. I show that a solution to the Hamilton-Jacobi-Bellman equation is the value function. The numerical comparative statics and mathematical analysis shows that, unlike in the constant relative risk aversion utility, present bias in the Epstein-Zin utility causes economically significant overconsumption, maintaining a plausible attitude toward risks. Additionally, I show that the sophisticated agent's preproperation occurs if and only if his or her elasticity of intertemporal substitution in consumption is larger than one.

THE INSTABILITY OF OPEN PARETO EFFICIENT ECONOMIES

This paper analyzes the impact of trade on the stability properties of trading countries and on stationary welfare. We consider a two-country two-good two-factor overlapping generations model where countries differ in terms of their technology. In the autarky equilibrium and the free-trade equilibrium, indeterminacy relies, under dynamic efficiency, on a capital intensive consumption good and intermediate values of the elasticity of intertemporal substitution in consumption. Opening the borders to trade can be a source of a global destabilizing effect. Indeed, considering a free-trade equilibrium in which one country is an exporter of the consumption good and the other country is an exporter of the investment good, indeterminacy can occur with trade even though the two countries are determinate in autarky. Finally, opening to trade increases the stationary welfare of the country that exports the investment good and deteriorates the one of the other country.

Present bias and the inefficiency of the centralized economy: The role of the elasticity of intertemporal substitution

We analyze an endogenous growth model considering agents with an isoelastic utility. Preferences are characterized by a utility affected by a negative externality, and a level of impatience which decays with the time distance from the present. Agents who cannot commit the actions of their future selves, play a game against them. The stationary equilibrium of this game defines a balanced growth path with a slower growth when played by subsequent central planners than when played by decision makers in the market economy. First, we prove that the fast growing market economy implies higher welfare if the negative externality is small, while the centralized economy is welfare improving above a given threshold for the externality (obtained for a specific family of non-constant discount functions). Secondly, we observe that this threshold increases with the elasticity of intertemporal substitution in consumption. Therefore, the greater this elasticity the more likely it is that the externality lies below this threshold, where policy interventions would not be adequate. Finally, as one would expect, the range of values of the externality for which the market equilibrium provides higher welfare widens the more different from constant discounting time preferences are, due either to a wider range of variation for the instantaneous discount rates or because these decay more slowly.

Necessary and Sufficient Conditions for Existence and Uniqueness of Recursive Utilities

ABSTRACTWe obtain exact necessary and sufficient conditions for existence and uniqueness of solutions of a class of homothetic recursive utility models postulated by Epstein and Zin. The conditions center on a single test value with a natural economic interpretation. The test sheds light on the relationship between valuation of cash flows, impatience, risk adjustment, and intertemporal substitution of consumption. We propose two methods to compute the test value when an analytical solution is not available. We further provide several applications.

The role of household debt and delinquency decisions in consumption-based asset pricing

I incorporate household debt and delinquency decisions into a standard model of lifecycle consumption-saving-investment. I also impose a punishment to the delinquent behavior by assuming that the percentage of endowment available is a linear function of the default decision. Theoretically such additional investor decisions are playing a relevant role in terms of completing markets. In practice, it enables me to derive an extended system of Euler equations which does not alter consumption-based fundamental asset pricing equation. It imposes the pricing kernel to account jointly for two additional first-order conditions. I perform empirical exercises aiming to price equity premium in United States from 1987:1 to 2018:1. I find significant elasticity of intertemporal substitution in consumption of the representative agent ranging from 0.24 to 0.55 and risk aversion from 1.82 to 3.51. This approach is also useful to account for the cross-section behavior of domestic assets. I can also use this framework to draw bounds for the household decisions on loan and delinquency and to propose a new rule of thumb relating preferences parameters and credit variables.

Analyzing the impact of workers’ remittances on household consumption in Latin American and Caribbean Countries

Increasing remittance flows to developing countries continue to stimulate analytical research. We apply a model, based on the “permanent income hypothesis”, to estimate the impact of remittances on consumption in eleven Latin American and Caribbean countries for the period of 2003–2013. The independent variables are: (a) real per capita national income (exclusive of remittances), the measure of “permanent income”, (b) remittances, the measure of “transitory income”, and (c) real interest rate, the indicator of intertemporal consumption substitution. The coefficient of remittances measures the consumption-augmentation and saving effects, while the correlation between remittances and per capita income indicates the consumption-smoothing effects. The results, based on the panel data methodology, indicate: (a) both permanent income and transitory income positively impact consumption, (b) consumption responds higher to permanent income than to transitory income, (c) transitory income has augmenting, stabilizing and countercyclical effects on consumption, and (d) the significant interest rate indicates the ability of recipients to make intertemporal consumption substitution. Evidence of significant “country effect” attests to heterogeneity among countries. Strategies to stabilize remittance flows and to leverage them for financial, economic and social development should be important policy considerations.

Intertemporal substitution in the Spanish economy: Evidence from regional data

AbstractThis paper studies the intertemporal substitution in consumption and leisure for the Spanish economy by estimating the first‐order conditions of an individual optimization model with regional and aggregate data. While first‐order conditions determining intertemporal substitution in consumption show a good econometric fit, and the value we obtain for the intertemporal elasticity of substitution is similar to previously available results, the econometric fit of the intertemporal condition in leisure indicates that the behaviour of the Spanish labour supply over the cycle is more complex than can be explained by the canonical intertemporal choice model.

Robust Portfolio Choice and Consumption with Derivative Trading Under Stochastic Volatility and Jumps

This paper analyzes the optimal consumption and portfolio choice problem for an ambiguity averse investor who has access to the stock and derivatives markets with recursive preferences. The stock process follows a stochastic volatility jump-diffusion model and the investor can have different levels of ambiguity about diffusion risks and the jump risk, respectively. We obtain an analytical solution which is exact when the investor has unit elasticity of intertemporal substitution of consumption, and approximate otherwise. We find that optimal exposures to diffusion risks and to the jump risk are significantly affected by the ambiguity aversion about the corresponding risk factors in the complete market. However, the optimal stock investment is insensitive to the ambiguity aversion about the jump risk in the incomplete market. We also find that considering ambiguity aversion with respect to diffusion risks and participating in the derivatives markets are essential to reduce the potential welfare loss, while the impact of ignoring the jump ambiguity is negligible.

On sunspot fluctuations in variable capacity utilization models

We investigate the extent to which standard one sector RBC models with positive externalities and variable capacity utilization can account for the large hump-shaped response of output when the model is submitted to a pure sunspot shock. We refine the Benhabib and Wen (2004) model considering a general type of additive separable preferences and a general production function. We provide a detailed theoretical analysis of local stabilities and local bifurcations as a function of various structural parameters. We show that, when labor is infinitely elastic, local indeterminacy occurs through Flip and Hopf bifurcations for a large set of values for the elasticity of intertemporal substitution in consumption, the degree of increasing returns to scale and the elasticity of capital–labor substitution. Finally, we provide a detailed quantitative assessment of the model and conclude with mixed results. We show that although the model is able theoretically to generate a hump-shaped dynamics of output following an i.i.d. sunspot shock under realistic parameter values, the hump is too persistent for the model to be considered fully satisfactory from an empirical point of view.

Elasticity of Intertemporal Substitution in Consumption in the Presence of Inertia: Empirical Evidence from a Natural Experiment

This paper estimates the elasticity of intertemporal substitution in consumption (σ) by exploiting a natural experiment provided by a change in the Indian banking legislation. The new legislation authorized banks to offer higher interest rates on deposits to citizens above 60 years of age. We find evidence that households exhibit inertia in reoptimization and are sensitive to the timing of the actual change in the interest rate. Households do not respond to the predictable changes in future interest rates induced by the change in the legislation. We incorporate this and estimate the σ to be approximately equal to 2.2. This paper was accepted by Amit Seru, finance.

CREDIT MARKETS AND INVESTMENT IN RENEWABLE ENERGY UNDER UNCERTAINTY

The present study examines the problem facing a resource-importing economy seeking to achieve energy independence by developing a renewable substitute. The invention of the substitute is assumed to follow a stochastic process that can be influenced by investment in energy research and development. I analyze the optimal investment strategy under alternative assumptions with respect to the economy's access to international financial markets, the terms on which credit is available, and the country's degree of dependence on resource imports. It is found that, in general, having access to capital markets does not necessarily lead to a higher investment rate. However, in the empirically relevant range of elasticity of intertemporal consumption substitution, the economy with access to credit invests more than under financial autarky. A higher degree of dependence on resource imports implies a lower optimal investment. Arrival of the substitute does not necessarily cause an immediate improvement in the net foreign asset position but may in fact cause its further deterioration.

Robust consumption and portfolio rules with time-varying model confidence

This paper investigates robust optimal consumption and portfolio rules for an Epstein-Zin type investor who is concerned about model misspecification. We propose a semi-explicit solution for the generalized problem of [Hansen, L., Sargent, T., 2001. Robust control and model uncertainty. The American Economic Review 91 (2), 60–66.]. Numerical results show that the optimal behaviors change dramatically according to the investor’s confidence level on the estimated model and that the elasticity of intertemporal substitution in consumption can affect investment ratio. In addition, we show how the investor decides her optimal behaviors for the worst-case scenario.

Measuring Intertemporal Substitution in Consumption: Evidence from a VAT Increase in Japan

Abstract We estimate the intertemporal elasticity of substitution in consumption (IES) using a preannounced increase in Japan’s consumption tax rate. Because this tax is highly comprehensive, the rate increase was announced prior to its implementation, and because other factors that affect the real interest rate were constant, the tax rate increase presents an ideal natural experiment to estimate the IES. A Japanese monthly household survey is exploited to accurately categorize nondurables, and our empirical specification addresses intratemporal substitution bias. We find that the IES is 0.21 and not significantly different from 0, but it is significantly less than 1.

Empirical Selection of Optimal Portfolios and its Influence in the Estimation of Kreps-Porteus Utility Function Parameters

This paper investigates the effects on the estimation of parameters related to the elasticity of intertemporal substitution and risk aversion, of the selection of different portfolios to represent the optimal aggregate wealth endogenously derived in equilibrium models with Kreps-Porteus recursive utility. We argue that the usual stock market wide index is not a good portfolio to represent optimal wealth of the representative agent, and we propose as an alternative the portfolio from the Investment Fund Industry. Especially for Brazil, where that industry invests most of its resources in fixed income, the aforementioned substitution of the optimal proxy portfolio caused a significant increase in the risk aversion coefficient and the elasticity of the intertemporal substitution in consumption.