Persistent vs. Permanent Income Shocks in the Buffer-Stock Model

TY - JOUR

T1 - Persistent vs. Permanent Income Shocks in the Buffer-Stock Model

AU - Druedahl, Jeppe

AU - Jørgensen, Thomas Høgholm

PY - 2017/1/1

Y1 - 2017/1/1

N2 - We investigate the effects of assuming a fully permanent income shock in a standard buffer-stock consumption model, when the true income process is only highly persistent. This assumption is computationally very advantageous, and thus often used, but might be problematic due to the implied misspecification. Across most parameterizations, and using the method of simulated moments, we find a relatively large estimation bias in preference parameters. For example, assuming a unit root process when the true AR(1) coefficient is 0.97, leads to an estimation bias of up to 30 percent in the constant relative risk aversion (CRRA) coefficient. If used for calibration, misspecified preferences could, for example, lead to a serious misjudgment in the value of social insurance mechanisms. Economic behavior, such as the marginal propensity to consume (MPC), of households simulated from the estimated (misspecified) model is, on the other hand, rather close to that from the correctly specified model.

AB - We investigate the effects of assuming a fully permanent income shock in a standard buffer-stock consumption model, when the true income process is only highly persistent. This assumption is computationally very advantageous, and thus often used, but might be problematic due to the implied misspecification. Across most parameterizations, and using the method of simulated moments, we find a relatively large estimation bias in preference parameters. For example, assuming a unit root process when the true AR(1) coefficient is 0.97, leads to an estimation bias of up to 30 percent in the constant relative risk aversion (CRRA) coefficient. If used for calibration, misspecified preferences could, for example, lead to a serious misjudgment in the value of social insurance mechanisms. Economic behavior, such as the marginal propensity to consume (MPC), of households simulated from the estimated (misspecified) model is, on the other hand, rather close to that from the correctly specified model.

KW - Faculty of Social Sciences

KW - imperfect markets life cycle model

KW - marginal propensity to consume

KW - persistent and permanent income shocks

KW - simulated method of moments

KW - D31

KW - D91

KW - E21

U2 - 10.1515/bejm-2016-0035

DO - 10.1515/bejm-2016-0035

M3 - Journal article

SN - 1935-1690

VL - 17

SP - 1

EP - 16

JO - B.E. Journal of Macroeconomics

JF - B.E. Journal of Macroeconomics

IS - 1

ER -