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Persistent vs. Permanent Income Shocks in the Buffer-Stock Model

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  • Druedahl Jeppe

    (Department of Economics, University of Copenhagen, Øster Farimagsgade 5, Building 26, DK-1353 Copenhagen, Denmark, Website: http://econ.ku.dk/druedahl)

  • Jørgensen Thomas H.

    (Department of Economics, University of Copenhagen, Denmark, Webpage: http://www.tjeconomics.com)

Abstract

We investigate the effects of assuming a fully permanent income shock in a standard buffer-stock consumption model, when the true income process is only highly persistent. This assumption is computationally very advantageous, and thus often used, but might be problematic due to the implied misspecification. Across most parameterizations, and using the method of simulated moments, we find a relatively large estimation bias in preference parameters. For example, assuming a unit root process when the true AR(1) coefficient is 0.97, leads to an estimation bias of up to 30 percent in the constant relative risk aversion (CRRA) coefficient. If used for calibration, misspecified preferences could, for example, lead to a serious misjudgment in the value of social insurance mechanisms. Economic behavior, such as the marginal propensity to consume (MPC), of households simulated from the estimated (misspecified) model is, on the other hand, rather close to that from the correctly specified model.

Suggested Citation

  • Druedahl Jeppe & Jørgensen Thomas H., 2017. "Persistent vs. Permanent Income Shocks in the Buffer-Stock Model," The B.E. Journal of Macroeconomics, De Gruyter, vol. 17(1), pages 1-16, January.
    • Handle: RePEc:bpj:bejmac:v:17:y:2017:i:1:p:16:n:9
    DOI: 10.1515/bejm-2016-0035
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    References listed on IDEAS

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    More about this item

    Keywords

    imperfect markets life cycle model; marginal propensity to consume; persistent and permanent income shocks; simulated method of moments;
    All these keywords.

    JEL classification:

    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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