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The Consumption-Wealth Ratio Under Asymmetric Adjustment

This paper argues that nonlinear adjustment may provide a better explanation of °uctuations in the consumption-wealth ratio. The nonlinearity is captured by a Markov-switching vector error-correction model that allows the dynamics of the relationship to di®er across regimes. Estimation of the system suggests that these states are related to the behaviour of ¯nancial markets. In fact, estimation of the system suggests that short-term deviations in the consumption-wealth ratio will forecast either asset returns or consumption growth: the ¯rst when changes in wealth are transitory; the second when changes in wealth are permanent. Our approach uncovers a richer and more complex dynamics in the consumption-wealth ratio than previous results in the literature, whilst being in accordance with theoretical predictions of a simple model of consumption under uncertainty.

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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 15/2007.

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Date of creation: 2007
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Handle: RePEc:nip:nipewp:15/2007
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  1. Zacharias Psaradakis & Martin Sola & Fabio Spagnolo, 2004. "On Markov error-correction models, with an application to stock prices and dividends," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 19(1), pages 69-88.
  2. James H. Stock & Mark W. Watson, 1991. "A simple estimator of cointegrating vectors in higher order integrated systems," Working Paper Series, Macroeconomic Issues 91-3, Federal Reserve Bank of Chicago.
  3. Hansen,B.E., 1999. "Testing for linearity," Working papers 7, Wisconsin Madison - Social Systems.
  4. Richard Paap & Herman K. van Dijk, 1999. "Bayes Estimates of Markov Trends in possibly Cointegrated Series: An Application to US Consumption and Income," Tinbergen Institute Discussion Papers 99-024/4, Tinbergen Institute.
  5. Massimo Guidolin & Allan Timmerman, 2006. "Asset allocation under multivariate regime switching," Working Papers 2005-002, Federal Reserve Bank of St. Louis.
  6. Garcia, Rene, 1998. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(3), pages 763-88, August.
  7. Sydney Ludvigson & Charles Steindel, 1999. "How important is the stock market effect on consumption?," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 29-51.
  8. Yash P. Mehra, 2001. "The wealth effect in empirical life-cycle aggregate consumption equations," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 45-67.
  9. Andrews, Donald W K & Monahan, J Christopher, 1992. "An Improved Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimator," Econometrica, Econometric Society, vol. 60(4), pages 953-66, July.
  10. James M. Poterba, 2000. "Stock Market Wealth and Consumption," Journal of Economic Perspectives, American Economic Association, vol. 14(2), pages 99-118, Spring.
  11. Martin Lettau & Sydney Ludvigson, 2003. "Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption," NBER Working Papers 9848, National Bureau of Economic Research, Inc.
  12. Hamilton, James D., 1996. "Specification testing in Markov-switching time-series models," Journal of Econometrics, Elsevier, vol. 70(1), pages 127-157, January.
  13. Camacho, Maximo, 2005. "Markov-switching stochastic trends and economic fluctuations," Journal of Economic Dynamics and Control, Elsevier, vol. 29(1-2), pages 135-158, January.
  14. Carrasco, Marine, 2002. "Misspecified Structural Change, Threshold, and Markov-switching models," Journal of Econometrics, Elsevier, vol. 109(2), pages 239-273, August.
  15. Morris A. Davis & Michael G. Palumbo, 2001. "A primer on the economics and time series econometrics of wealth effects," Finance and Economics Discussion Series 2001-09, Board of Governors of the Federal Reserve System (U.S.).
  16. Andrews, Donald W K & Ploberger, Werner, 1994. "Optimal Tests When a Nuisance Parameter Is Present Only under the Alternative," Econometrica, Econometric Society, vol. 62(6), pages 1383-1414, November.
  17. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
  18. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
  19. Massimo Guidolin, University of Virginia & Allan Timmermann, 2004. "Strategic Asset Allocation and Consumption Decisions under Multivariate Regime Switching," Econometric Society 2004 Australasian Meetings 349, Econometric Society.
  20. Driffill, John & Sola, Martin, 1998. "Intrinsic bubbles and regime-switching," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 357-373, July.
  21. Robert B. Davies, 2002. "Hypothesis testing when a nuisance parameter is present only under the alternative: Linear model case," Biometrika, Biometrika Trust, vol. 89(2), pages 484-489, June.
  22. Hansen, Bruce E., 1992. "Testing for parameter instability in linear models," Journal of Policy Modeling, Elsevier, vol. 14(4), pages 517-533, August.
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