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The Rate of Interest or the Rate of Return: Estimating Intertemporal Elasticity of Substitution

  • Douglas Dacy

    (University of Texas at Austin)

  • Fuad Hasanov

    (Oakland University)

This paper investigates whether the rate of interest such as the Treasury bill rate or the rate of return such as the return on a household portfolio is more relevant to the household’s intertemporal decision making. In a current era, households are diversifiers (to use Tobin’s 1958 term) and hold portfolios of assets rather than a simple loan. A portfolio of assets earns a composite return accounting for capital gains, taxes, and inflation, and rational agents make spending decisions based on expected total returns on a portfolio rather than on the return on a single asset. The total composite measure we use includes financial assets such as stocks and bonds and a real asset, residential housing. In particular, we estimate the intertemporal elasticity of substitution, namely, how a change in the asset or portfolio return affects household’s consumption growth. The estimates obtained using real after-tax composite return are about 0.15-0.3 and are more robust to linear and nonlinear estimations, different consumption measures, and various time periods than those obtained by using individual asset returns such as the Treasury bill rate.

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File URL: http://econwpa.repec.org/eps/mac/papers/0510/0510012.pdf
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Paper provided by EconWPA in its series Macroeconomics with number 0510012.

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Date of creation: 11 Oct 2005
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Handle: RePEc:wpa:wuwpma:0510012
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  1. Joe Peek & James A. Wilcox, 1984. "The Degree of Fiscal Illusion in Interest Rates: Some Direct Estimates," NBER Working Papers 1358, National Bureau of Economic Research, Inc.
  2. N. Gregory Mankiw, 1987. "Consumer Spending and the After-Tax Real Interest Rate," NBER Chapters, in: The Effects of Taxation on Capital Accumulation, pages 53-68 National Bureau of Economic Research, Inc.
  3. Martin Feldstein & Jerry Green & Eytan Sheshinski, 1983. "Inflation and Taxes in a Growing Economy with Debt and Equity Finance," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 44-60 National Bureau of Economic Research, Inc.
  4. Barro, Robert J & Sahasakul, Chaipat, 1983. "Measuring the Average Marginal Tax Rate from the Individual Income Tax," The Journal of Business, University of Chicago Press, vol. 56(4), pages 419-52, October.
  5. Slesnick, Daniel T, 1998. "Are Our Data Relevant to the Theory? The Case of Aggregate Consumption Expenditures, and Empirical Consumption and Savings," Journal of Business & Economic Statistics, American Statistical Association, vol. 16(1), pages 52-61, January.
  6. Casey B. Mulligan, 2002. "Capital, Interest, and Aggregate Intertemporal Substitution," NBER Working Papers 9373, National Bureau of Economic Research, Inc.
  7. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
  8. Robert E. Hall, 1987. "Consumption," NBER Working Papers 2265, National Bureau of Economic Research, Inc.
  9. Mishkin, Frederic S., 1981. "The real interest rate: An empirical investigation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 151-200, January.
  10. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  11. Orazio P. Attanasio & Guglielmo Weber, 1994. "Is Consumption Growth Consistent with Intertemporal Optimization? Evidence from the Consumer Expenditure Survey," NBER Working Papers 4795, National Bureau of Economic Research, Inc.
  12. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March.
  13. Joe Peek & James A. Wilcox, 1986. "Tax rates and interest rates on tax-exempt securities," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 29-41.
  14. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
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