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Mismeasurement of the Elasticity of Intertemporal Substitution:The Role of Limited Stock Market Participation

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  • Muhammet Fatih Guvenen

Abstract

In this paper, we reconcile two opposing views about the elasticity of intertemporal substitution (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. 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 analyze a dynamic economy which incorporates both kinds of heterogeneity. We find that limited participation creates substantial wealth inequality matching that in U.S. data. Consequently, the dynamic behavior of output and investment is almost entirely determined by the preferences of the wealthy minority of households. 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). Our model also matches a number of cross-sectional features of the U.S. data that are otherwise difficult to explain. Finally, using simulated data generated by our heterogeneous-agent model, we show that the econometric methods used by Hall and others produce biased estimates of the average EIS across individuals. In particular, ignoring the correlation of instruments with (the omitted) conditional variances in the log-linearized Euler equation biases the estimate of the EIS downward by as much as 60%.

Suggested Citation

  • Muhammet Fatih Guvenen, 2000. "Mismeasurement of the Elasticity of Intertemporal Substitution:The Role of Limited Stock Market Participation," GSIA Working Papers 2000-E26, Carnegie Mellon University, Tepper School of Business.
  • Handle: RePEc:cmu:gsiawp:386
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    Cited by:

    1. Yacine Ait-Sahalia & Jonathan A. Parker & Motohiro Yogo, 2001. "Luxury Goods and the Equity Premium," NBER Working Papers 8417, National Bureau of Economic Research, Inc.
    2. Ravi Bansal, 2007. "Long-run risks and financial markets," Review, Federal Reserve Bank of St. Louis, vol. 89(Jul), pages 283-300.
    3. David Domeij & Martin Floden, 2006. "The Labor-Supply Elasticity and Borrowing Constraints: Why Estimates are Biased," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 242-262, April.
    4. repec:idn:jimfjn:v:4:y:2018:i:1f:p:1-16 is not listed on IDEAS
    5. Salman Ahmed Shaikh & Mohd Adib Ismail & Abdul Ghafar Ismail & Shahida Shahimi & Muhammad Hakimi Mohd. Shafiai, 2018. "An Empirical Investigation Of Consumption Behaviour In Selected Oic Countries," Journal of Islamic Monetary Economics and Finance, Bank Indonesia, vol. 4(1), pages 101-116, August.
    6. Benzoni, Luca & Collin-Dufresne, Pierre & Goldstein, Robert S., 2011. "Explaining asset pricing puzzles associated with the 1987 market crash," Journal of Financial Economics, Elsevier, vol. 101(3), pages 552-573, September.
    7. Jonathan Gruber, 2013. "A Tax-Based Estimate of the Elasticity of Intertemporal Substitution," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 3(01), pages 1-20.
    8. repec:pri:wwseco:dp222 is not listed on IDEAS

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