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Time-Varying Returns, Intertemporal Substitution and Cyclical Variation in Consumption

  • De Veirman Emmanuel

    ()

    (Reserve Bank of New Zealand)

  • Dunstan Ashley

    ()

    (Reserve Bank of New Zealand)

This paper studies the importance of intertemporal substitution in consumption for the cyclical co-movement of consumption, net worth and income. We can largely explain the empirical hump-shaped consumption response to a transitory wealth increase by allowing for time-varying returns in an otherwise standard Permanent Income Hypothesis (PIH) model. At the net worth peak, households bring consumption forward in anticipation of low returns on saving. The PIH model fully explains the empirical response when households initially expect the net worth shock to be permanent, but gradually learn that it is in fact transitory.

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Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 11 (2011)
Issue (Month): 1 (July)
Pages: 1-41

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Handle: RePEc:bpj:bejmac:v:11:y:2011:i:1:n:23
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