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Testing Consumption Optimality using Aggregate Data

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  • Gomes, Fábio Augusto Reis
  • Issler, João Victor

Abstract

The objective of this paper is to test for optimality of consumption decisions at theaggregate level (representative consumer) taking into account popular deviations from thecanonical CRRA utility model rule of thumb and habit. First, we show that rule-of-thumbbehavior in consumption is observational equivalent to behavior obtained by the optimizingmodel of King, Plosser and Rebelo (Journal of Monetary Economics, 1988), casting doubt onhow reliable standard rule-of-thumb tests are. Second, although Carroll (2001) and Weber(2002) have criticized the linearization and testing of euler equations for consumption, weprovide a deeper critique directly applicable to current rule-of-thumb tests. Third, we showthat there is no reason why return aggregation cannot be performed in the nonlinear setting ofthe Asset-Pricing Equation, since the latter is a linear function of individual returns. Fourth,aggregation of the nonlinear euler equation forms the basis of a novel test of deviationsfrom the canonical CRRA model of consumption in the presence of rule-of-thumb and habitbehavior. We estimated 48 euler equations using GMM, with encouraging results vis-a-vis theoptimality of consumption decisions. At the 5% level, we only rejected optimality twice outof 48 times. Empirical-test results show that we can still rely on the canonical CRRA modelso prevalent in macroeconomics: out of 24 regressions, we found the rule-of-thumb parameter ƛ to be statistically signi cant at the 5% level only twice, and the habit ƴ parameter to bestatistically signi cant on four occasions. The main message of this paper is that proper return aggregation is critical to studyintertemporal substitution in a representative-agent framework. In this case, we fi nd littleevidence of lack of optimality in consumption decisions, and deviations of the CRRA utility model along the lines of rule-of-thumb behavior and habit in preferences represent theexception, not the rule.

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 752.

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Date of creation: 02 Jun 2014
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Handle: RePEc:fgv:epgewp:752

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