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Estimating the Elasticity of Intertemporal Substitution Using Mortgage Notches

Author

Listed:
  • Michael Carlos Best
  • James S Cloyne
  • Ethan Ilzetzki
  • Henrik J Kleven

Abstract

Using a novel source of quasi-experimental variation in interest rates, we develop a new approach to estimating the Elasticity of Intertemporal Substitution (EIS). In the U.K., the mortgage interest rate features discrete jumps—notches—at thresholds for the loan-to-value (LTV) ratio. These notches generate large bunching below the critical LTV thresholds and missing mass above them. We develop a dynamic model that links these empirical moments to the underlying structural EIS. The average EIS is small, around 0.1, and quite homogeneous in the population. This finding is robust to structural assumptions and can allow for uncertainty, a wide range of risk preferences, portfolio reallocation, liquidity constraints, present bias, and optimization frictions. Our findings have implications for the numerous calibration studies that rely on larger values of the EIS.

Suggested Citation

  • Michael Carlos Best & James S Cloyne & Ethan Ilzetzki & Henrik J Kleven, 2020. "Estimating the Elasticity of Intertemporal Substitution Using Mortgage Notches," Review of Economic Studies, Oxford University Press, vol. 87(2), pages 656-690.
  • Handle: RePEc:oup:restud:v:87:y:2020:i:2:p:656-690.
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    File URL: http://hdl.handle.net/10.1093/restud/rdz025
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    Cited by:

    1. Jonathan Gruber & Thomas P. Hoe & George Stoye, 2018. "Saving Lives by Tying Hands: The Unexpected Effects of Constraining Health Care Providers," NBER Working Papers 24445, National Bureau of Economic Research, Inc.
    2. Benetton, Matteo & Bracke, Philippe & Cocco, João F & Garbarino, Nicola, 2019. "Housing consumption and investment:evidence from shared equity mortgages," Bank of England working papers 790, Bank of England.
    3. Gaffney, Edward, 2019. "Mortgage borrowers at the loan-to-income limit," Financial Stability Notes 11/FS/19, Central Bank of Ireland.
    4. Birru, Justin & Chague, Fernando & De-Losso, Rodrigo & Giovannetti, Bruno, 2019. "Attention and Biases: Evidence from Tax-Inattentive Investors," Working Paper Series 2019-22, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    5. Fergus Cumming, 2019. "Mortgage Cash-flows and Employment," Discussion Papers 1922, Centre for Macroeconomics (CFM).
    6. Christopher D. Cotton, 2020. "The Inflation Target and the Equilibrium Real Rate," Working Papers 20-2, Federal Reserve Bank of Boston, revised 01 Feb 2020.
    7. Xia, Tian, 2020. "The role of intermediate goods in international monetary cooperation," Journal of International Money and Finance, Elsevier, vol. 100(C).

    More about this item

    Keywords

    Elasticity of Intertemporal Substitution; mortgage borrowing; interest rate notches; bunching; structural estimation;

    JEL classification:

    • D1 - Microeconomics - - Household Behavior
    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
    • H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household

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