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Forecasting Consumption Growth with the Real Term Structure

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  • Kwok Ping Tsang

Abstract

From the log-linearized consumption Euler equation, consumption growth of any horizon m is a function of the expected real return of maturity m, and they are linked through the elasticity of intertemporal substitution (EIS). Instead of using only the 1- period return and consumption growth, this result allows us to use the term structure of interest rates to identify the EIS. Using quarterly US data from 1954Q1 to 2007Q4, GMM results show that the real term structure is unrelated to future consumption growth: after controlling for small sample bias, we cannot reject the hypothesis that the EIS is zero. However, allowing a break in 1979 changes the results dramatically: the EIS is around 0.4 in the first period and it drops to around 0.2 in the second period. Not only is the EIS smaller, the out-sample forecasting power of ex post real return also drops in the second subsample compared to a simple AR(1) model for consumption growth. I find a lower EIS also for annual data.

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File URL: ftp://repec.econ.vt.edu/Papers/Tsang/consumption_growth.pdf
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Bibliographic Info

Paper provided by Virginia Polytechnic Institute and State University, Department of Economics in its series Working Papers with number e07-14.

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Length: 26 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:vpi:wpaper:e07-14

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Keywords: Consumption Euler Equation; Term Structure of Interest Rates; Inflation; Forecast; Elasticity of Intertemporal Substitution; GMM;

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  1. Fatih Guvenen, 2005. "Reconciling Conflicting Evidence on the Elasticity of Intertemporal Substitution: A Macroeconomic Perspective," Macroeconomics 0507005, EconWPA.
  2. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  3. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
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  8. Attanasio, Orazio P & Weber, Guglielmo, 1989. "Intertemporal Substitution, Risk Aversion and the Euler Equation for Consumption," Economic Journal, Royal Economic Society, vol. 99(395), pages 59-73, Supplemen.
  9. Richard Blundell & Martin Browning & Costas Meghir, 1993. "Consumer demand and the life-cycle allocation of household expenditures," IFS Working Papers W93/11, Institute for Fiscal Studies.
  10. Diebold, Francis X. & Rudebusch, Glenn D. & Borag[caron]an Aruoba, S., 2006. "The macroeconomy and the yield curve: a dynamic latent factor approach," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 309-338.
  11. Reinhart, Carmen & Ogaki, Masao, 1995. "Measuring intertemporal substitution: The role of durable goods," MPRA Paper 13690, University Library of Munich, Germany.
  12. Harvey, Campbell R., 1988. "The real term structure and consumption growth," Journal of Financial Economics, Elsevier, vol. 22(2), pages 305-333, December.
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  14. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June.
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