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Reconciling Conflicting Evidence on the Elasticity of Intertemporal Substitution: A Macroeconomic Perspective

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This paper attempts to reconcile two opposing views about the elasticity of intertemporal substitution in consumption (EIS), a parameter that plays a key role in macroeconomic analysis. On the one hand, empirical studies using aggregate consumption data typically find that the EIS is close to zero (Hall, 1988). On the other hand, calibrated macroeconomic models designed to match growth and business cycle facts typically require that the EIS be close to one (Weil, 1989, Lucas, 1990, among others). We show that this apparent contradiction arises from ignoring two kinds of heterogeneity across individuals. First, a large fraction of households in the U.S. do not participate in stock markets. Second, a variety of microeconomic studies using individual-level data conclude that an individual's EIS increases with his wealth. We study a dynamic macroeconomic model featuring these two realistic sources of heterogeneity which have been largely assumed away in macroeconomics to date. We find that limited participation creates substantial wealth inequality matching that in U.S. data. Consequently, the properties of aggregate variables directly linked to wealth, such as investment and output, are almost entirely determined by the (high-elasticity) stockholders. At the same time, since consumption is much more evenly distributed across households than is wealth, estimation using aggregate consumption uncovers the low EIS of the majority of households (i.e., the poor). Moreover, this parsimonious model is also able to explain key cross-sectional facts of the U.S. data that have proved difficult to understand previously, suggesting that it can be a useful framework for studying a range of macroeconomic and policy questions.

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Bibliographic Info

Paper provided by University of Rochester - Center for Economic Research (RCER) in its series RCER Working Papers with number 491.

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Length: 41 pages
Date of creation: May 2002
Date of revision: Mar 2003
Handle: RePEc:roc:rocher:491

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Postal: University of Rochester, Center for Economic Research, Department of Economics, Harkness 231 Rochester, New York 14627 U.S.A.

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Keywords: Elasticity of intertemporal substitution; limited stock market participation; incomplete markets; wealth inequality; capital income taxation.;

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