Non-separable Preferences Research Articles

Risk Aversion and the Value of Life

We show that state non-separable preferences a la Epstein–Zin–Weil (EZW) provide a tractable and flexible framework to study the economics of health and longevity. This utility representation: (1) admits a preference for timing of resolution of uncertainty regarding mortality risks; (2) links the marginal valuation of survival to the level of survival; (3) can preserve homotheticity even for low degrees of intertemporal substitution without generating implausible predictions regarding the value of life; and (4) adds needed flexibility to account for the empirical evidence on the value of life. We illustrate the implications of EZW preferences for the economic value of observed differences in life expectancy across countries and over time, and for the value of life over the life cycle.

News shocks, nonseparable preferences, and optimal monetary policy

Extending and modifying the canonical New Keynesian (NK) model by embedding a nonseparable Jaimovich/Rebelo (2009)-type utility function, this study provides a novel approach to examine the impact of anticipated shocks, called “news shocks”, on business cycles. It can be shown that news shocks cause larger economic fluctuations than unanticipated shocks of the same form and thus behave in a welfare-reducing manner. Given this, the paper explores how (optimal) monetary policy should be conducted. In line with earlier studies, the investigation of several Taylor-type interest rate rules shows that the lowest welfare losses can be achieved based on rules that respond to both contemporaneous and expected future macroeconomic conditions.

NONSEPARABLE PREFERENCES DO NOT RULE OUT AGGREGATE INSTABILITY UNDER BALANCED-BUDGET RULES: A NOTE

We investigate the role of nonseparable preferences in the occurrence of macroeconomic instability under a balanced-budget rule where government spending is financed by a tax on labor income. Considering a one-sector neoclassical growth model with a large class of nonseparable utility functions, we find that expectations-driven fluctuations occur easily when consumption and labor are Edgeworth substitutes or weak Edgeworth complements. Under these assumptions, an intermediate range of tax rates and a sufficiently low elasticity of intertemporal substitution in consumption lead to instability.

On the size of the government spending multiplier in the euro area

This article addresses the existence of a wide range of estimated government spending multipliers in a dynamic stochastic general equilibrium model of the euro area. Our estimation results and counterfactual exercises provide evidence that omitting the interactions of key ingredients at the estimation stage (such as Edgeworth complementarity/subtitutability between private consumption and government expenditures, endogenous government spending policy and general time nonseparable preferences) paves the way for potentially large biases. We argue that uncertainty on the quantitative assessments of fiscal programmes could partly originate from these biases.

Multidimensional Spatial Voting with Non-separable Preferences

In most multidimensional spatial models, the systematic component of agent utility functions is specified as additive separable. We argue that this assumption is too restrictive, at least in the context of spatial voting in mass elections. Here, assuming separability would stipulate that voters do not care about how policy platforms combine positions on multiple policy dimensions. We present a statistical implementation of Davis, Hinich, and Ordeshook's (1970) Weighted Euclidean Distance model that allows for the estimation of the direction and magnitude of non-separability from vote choice data. We demonstrate in a Monte-Carlo experiment that conventional separable model specifications yield biased and/or unreliable estimates of the effect of policy distances on vote choice probabilities in the presence of non-separable preferences. In three empirical applications, we find voter preferences on economic and socio-cultural issues to be non-separable. If non-separability is unaccounted for, researchers run the risk of missing crucial parts of the story. The implications of our findings carry over to other fields of research: checking for non-separability is an essential part of robustness testing in empirical applications of multidimensional spatial models.

Evidence that Risk Adjustment is Unnecessary in Estimates of the User Cost of Money

Investors value the special attributes of monetary assets (e.g., exchangeability, liquidity, and safety) and pay a premium for holding them in the form of a lower return rate. The user cost of holding monetary assets can be measured approximately by the difference between the returns on illiquid risky assets and those of safer liquid assets. A more appropriate measure should adjust this difference by the differential risk of the assets in question. We investigate the impact that time non-separable preferences has on the estimation of the risk-adjusted user cost of money. Using U.K. data from 1965Q1 to 2011Q1, we estimate a habit-based asset pricing model with money in the utility function and find that the risk adjustment for risky monetary assets is negligible. Thus, researchers can dispense with risk adjusting the user cost of money in constructing monetary aggregate indexes.

Albert Heckscher on collective decision-making

Albert Heckscher (1857–1897) was a Danish lawyer. In his dissertation (Bidrag till Grundlaeggelse af en Afstemningslaere), accepted in 1892 at the University of Copenhagen, Heckscher dealt with numerous issues related to voting, especially those related to vote-aggregation in parliaments, courts and committees. He knew the works of Condorcet and Borda quite well, and analyzed many topics that would nowadays fall into the domain of the theory of social choice. These include Condorcet-cycles, differences between Condorcet-effective rules and the Borda rule, strategic voting, the influence of the voting order under the parliamentary voting rules, the likelihood of single-peaked preference profiles, and the problems created by non-separable preferences. Heckscher’s treatment of the Judgment Aggregation Paradox is especially noteworthy. Although Kornhauser and Sager (Yale Law Journal 96: 82–117, 1986) are usually mentioned as the inventors of this problem, Heckscher’s earlier treatment confirms the suspicion that the problem is not of recent origin. Numerous issues studied in the post-Arrowian theory of voting may already be found in Heckscher’s dissertation; some of them have become subjects of systematic study only in the twenty-first century. It is argued that Albert Heckscher, the unknown nineteenth century Danish lawyer, deserves a place in the pantheon of the theory of social choice alongside his better known contemporaries Charles Dodgson and E. J. Nanson.

Investment shocks and consumption

Several influential papers have argued that preferences featuring a weak wealth effect on labour supply are key to generate macroeconomic co-movement across real variables in response to shocks. Using a fully general specification for the instantaneous utility function, we show that the size of the wealth effect on labour supply is largely inconsequential for macroeconomic dynamics. Instead, we find that Edgeworth complementarity between consumption and hours worked is crucial in order to obtain co-movement of key macroeconomic variables. We consider investment shocks and we show that co-movement can easily be achieved with non-separable preferences in combination with a reasonable degree of nominal rigidity. This holds even in the presence of sizeable wealth effects.

Evidence for state and time nonseparable preferences: the case of Finland

Preferential modifications to the standard state and time separable power utility are studied for the Finnish equity and bond returns. The reported ambivalence of the high equity premium and low Sharpe ratio makes the Finnish market an important case study. The estimations of the Epstein and Zin (1991) recursive utility and the Campbell and Cochrane (1999) habit formation preferences show that Finnish risk premia are time-varying across samples. Moreover, the results demonstrate that stronger time preferences improve the explanation of asset returns for the modified preferences more so than assuming tighter time preference and higher risk aversion (RA). We conclude that the Campbell–Cochrane-based pricing kernel outperforms the competing models in generating plausible model parameters and suppressing specification errors. The study supports the US evidence relative to the conclusions drawn from the European economies in comparable studies.

Evaluating monetary policy under preferences with zero wealth effect: A Bayesian approach

Both real and monetary macro models have parallely exploited the potential for various preferences in accounting for empirical facts. This paper brings the two literatures together by estimating time non-separable preferences with habit formation in consumption that nests several commonly used preferences. In the absence of wealth effects and external habits, these preferences fail to generate observed inflation inertia and output persistence after a monetary policy shock. Furthermore, the data strongly rejects these preferences in favor of preferences with external habits. An alternative solution is to include habit adjusted intermediate wealth effect preferences which are able to simultaneously generate sluggish responses of the variables to a monetary policy shock and fit the data better.

The delayed effects of monetary shocks in a two-sector New Keynesian model

This paper studies a two-sector New Keynesian model that captures the hump-shaped response of non-durable and durable spending to a monetary shock when non-durable prices are sticky and durable goods are flexibly priced. Based on the estimated parameters, we show that habit formation and investment adjustment costs are not sufficient to generate the gradual response of non-durable and durable spending in this setup. We find that nominal wage rigidity and non-separable preferences between consumption and labor are also necessary to delay the peak response of non-durable and durable spending in the estimated two-sector New Keynesian model.

The merits of adding complexity: non-separable preferences in spatial models of European Union politics

This paper challenges the assumption of separable preferences that has been applied throughout the existing empirical research on European Union (EU) legislative politics. Yet our analysis reveals that non-separable preferences are in fact a widespread phenomenon in EU politics. In many cases actors’ spending preferences are conditional upon the expected policy outcome, but not vice versa. In order to appropriately model such non-reciprocity, we propose a simple modification to the standard Euclidean utility function. Applying simulation techniques, we demonstrate that overlooking non-separable preferences may have caused a substantial bias in the empirical evaluation of competing models of EU legislative politics. Specifically, models that constrain the set of feasible outcomes to either the Winset and/or the core must rely on a correct specification of actors’ utility functions. Therefore, a false assumption of core separable preferences significantly disadvantages these models vis-à-vis unconstrained models. Moreover, our findings underline the agenda-setting power of the European Commission for proposals that involve either a spending decision or the delegation of power from the national to the European level.

Time Use During the Great Recession

Using data from the American Time Use Survey between 2003 and 2010, we document that home production absorbs roughly 30 percent of foregone market work hours at business cycle frequencies. Leisure absorbs roughly 50 percent of foregone market work hours, with sleeping and television watching accounting for most of this increase. We document significant increases in time spent on shopping, child care, education, and health. Job search absorbs between 2 and 6 percent of foregone market work hours. We discuss the implications of our results for business cycle models with home production and non-separable preferences. (JEL D31, E32, J22)

Government Spending, Consumption, and the Extensive Investment Margin

We find VAR evidence that a rise in US government spending boosts consumption and firm entry. The joint dynamics observed in the data poses a puzzle for business cycle models with endogenous entry (extensive-margin investment). Persistent spending expansions generate entry but crowd out consumption through a negative wealth effect. Model features that dampen the wealth effect, such as credit-constrained consumers or non-separable preferences, reduce entry. This leads to weaker competition in oligopolistic markets, such that markups rise and consumption falls. The model captures the joint dynamics if labor supply is very elastic or public and private consumption are complements.

Non-separability and sectoral comovement in a sticky price model

This paper resolves the sectoral comovement problem between nondurable and durable outputs that arises in response to a monetary shock in a two-sector sticky price model with flexibly priced durable goods. We analytically demonstrate that the non-separability between aggregate consumption and labor can generate the comovement between nondurable and durable outputs in response to a monetary policy shock. We then estimate the degree of non-separability, together with other parameters, using a Bayesian approach. We find that the non-separable preferences are supported by the data and our estimated model generates the sectoral comovement in response to a monetary shock.

Consumption, retirement and social security: Evaluating the efficiency of reform that encourages longer careers

This paper proposes and analyzes a Social Security reform in which individuals no longer face the OASI payroll tax after, say, age 54 or a career of 34 years, and their subsequent earnings have no bearing on their benefits. We first estimate parameters of a life-cycle model. Our specification includes non-separable preferences and possible disability. It predicts a consumption–expenditure change at retirement. We use the magnitude of the expenditure change, together with households' retirement-age decisions, to identify key structural parameters. The estimated magnitude of the change in consumption–expenditure depends importantly on the treatment of consumption by adult children of the household. Simulations indicate that the reform could increase retirement ages one year or more, equivalent variations could average more than $4000 per household, and income tax revenues per household could increase by more than $14,000.

International business cycles with complete markets

Kehoe and Perri (2002) show that a two-country business cycle model with endogenously incomplete markets helps to resolve the “international comovement puzzle” (Baxter, 1995) and the “quantity anomaly” (Backus et al., 1992, 1995). We claim that a similar performance can be achieved without resorting to market incompleteness. We show that a model with complete markets driven by productivity shocks alone can account for the “international comovement puzzle”. Our model features time nonseparable preferences that allow arbitrarily small wealth effects on labor supply. It matches the data by predicting (i) positive cross-country correlations of investment and hours worked; (ii) realistic cross-country correlations of consumption. It reduces the gap between international correlations of output and consumption, but fails to change their order. Unlike models with restricted international markets, ours show little sensitivity to the parameterization of the forcing process.

Cost-conscious voters in referendum elections

In referendum elections, voters are frequently required to register simultaneous yes/no votes on multiple proposals. The separability problem occurs when a voter’s preferred outcome on a proposal or set of proposals depends on the known or predicted outcomes of other proposals in the election. Here we investigate cost-consciousness as a potential cause of nonseparability. We develop a mathematical model of cost-consciousness, and we show that this model induces nonseparable preferences in all but the most extreme cases. We show that when outcome costs are distinct, cost-conscious electorates always exhibit both a weak Condorcet winner and a weak Condorcet loser. Finally, we show that preferences consistent with our model of cost-consciousness are rare in randomly generated electorates. We then discuss the implications of our work and suggest directions for further research.

The Mathematics of Referendum Elections and Separable Preferences

SummaryVoters in referendum elections are often required to cast simultaneous ballots on several possibly related questions or proposals. The separability problem occurs when a voter's preferences on one question or set of questions depend on the known or predicted outcomes of other questions. Nonseparable preferences can lead to seemingly paradoxical election outcomes, such as a winning outcome that is the last choice of every voter. In this article, we survey recent mathematical results related to the separability problem in referendum elections. We explore the structure of interdependent preferences, consider related combinatorial and algebraic results, and examine the practical impact of separability on the outcomes of referendum elections.

INFLATION AND UNEMPLOYMENT IN COMPETITIVE SEARCH EQUILIBRIUM

Rocheteau, Rupert, and Wright [Scandinavian Journal of Economics 109 (2007), 837–855] show that the relationship between inflation and unemployment can be positive or negative, depending on the primitives of the model. The key features are indivisible labor, nonseparable preferences, and bargaining. Their results are derived only for a special case of bargaining, take-it-or-leave-it offer by buyers. Instead of bargaining, this paper considers competitive search. I show that the results of Rocheteau et al. can be generalized to an environment where both buyers and sellers have nonseparable preferences. In addition, the relationship between inflation and unemployment is robust to allowing free entry by sellers, which cannot be studied in Rocheteau et al. (2007).