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Approximation bias in linearized Euler equations

  • Sydney Ludvigson
  • Christina H. Paxson

This paper concerns pitfalls associated with the use of approximations to dynamic Euler equations. Two applications of the approximations are notable. First, tests for precautionary saving motives typically involve regressing consumption growth on uncertainty in expected consumption growth. The parameter estimates are used to measure the strength of precautionary motives, which is also related to the coefficient of relative risk aversion. Another application estimates the sensitivity of consumption growth to the expected real interest rate, with the coefficient on the latter equal to the intertemporal elasticity of substitution in consumption, often the inverse of the coefficient of relative risk aversion. The two literatures yield very different estimates of how prudent or risk averse consumers are or, alternatively, how willing they are to substitute consumption over time. We investigate one possible reason for these apparently contradictory results: both methods of estimation rely on linear approximations of Euler equations. We demonstrate that biases associated with these approximations can be substantial, and that the direction of the biases is consistent with the divergent estimates found in the literature.

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Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9712.

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Date of creation: 1997
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Handle: RePEc:fip:fednrp:9712
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  1. Christopher D. Carroll & Miles S. Kimball, 1995. "On the concavity of the consumption function," Finance and Economics Discussion Series 95-10, Board of Governors of the Federal Reserve System (U.S.).
  2. Christopher D Carroll, 1997. "Death to the Log-Linearized Consumption euler Equation! (And Very Poor Health to the Second-Order Approximation)," Economics Working Paper Archive 390, The Johns Hopkins University,Department of Economics.
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  12. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, vol. 18(1), pages 83-114, January.
  13. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June.
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  15. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1992. "Earnings Uncertainty and Precautionary Saving," CEPR Discussion Papers 699, C.E.P.R. Discussion Papers.
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  26. repec:fth:harver:1435 is not listed on IDEAS
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