On the use of elasticity of intertemporal substitution. We provide two ways to reconcile small values of the intertemporal elasticity of substitution ies that range between 0. The intertemporal elasticity of substitution ies is a key economic parameter for the. Crump, stefano eusepi, andrea tambalotti, and giorgio topa federal reserve bank of new york staff reports, no. This step requires a numerical solution of the second stage of twostage budgeting to construct the indirect felicity function and its partial derivatives. Temporal and intertemporal utility functions application center. The role of risk aversion and intertemporal substitution in. Elasticity of intertemporal substitution wikipedia. Elasticity of a function of a single variable before we meet this guest, let us spend a bit of time with a slightly simpler notion, the elasticity of a a function of a single variable. The intertemporal elasticity of substitution ies is a key parameter that characterizes household consumption and saving behaviour, and it plays a crucial role in determining policy and welfare assessments, where the positive value of the ies is the basic premise of theoretical or quantitative analysis. Estimating the intertemporal substitution elasticity.
Later empirical studies, however, reject the intertemporal substitution in consumption hypothesis, because consumption seems to be overly sensitive to present income. Intertemporal substitution is the decision to forego current consumption in order to consume in the future. Essays on the elasticity of intertemporal substitution iowa research. The elasticity of intergenerational substitution, parental.
But avoid asking for help, clarification, or responding to other answers. Hall stanford university and national bureau of economic research one of the important determinants of the response of saving and consumption to the real interest rate is the elasticity of intertemporal substitution. Measuring intertemporal substitution in consumption. The return to wealth, asset pricing, and the intertemporal elasticity. This paper denes the concept of elasticity of intergenerational substitution egs, and extends a standard dynastic model in order to disentangle the egs from the eis, or elasticity of intertemporal substitution. It plays a key role in the theory of consumption and saving, in particular in the lifecycle version of that theory. The third panel in table 2 performs a similar exercise, this time holding the intratemporal elasticity of substitution in consumption at its benchmark value. Graphically, in the 1 2 space, the inverse of the tellsushow the slope of the indi. In the uk, the mortgage interest rate features discrete jumps notches at thresholds for the loantovalue ltv ratio. Estimates using smf returns suggest that this elasticity is positive and small. One of the most important behavioral parameters in macroeconomics is the elasticity of intertemporal substitution eis. In all common models of inter temporal allocation, the assumption of a constant elasticity of intertemporal substitution eis imposes surprising limitations on withinperiod budget allocations. On the use of elasticity of intertemporal substitution aleksandar georgiev. Consequently, the constant eis assumption can be tested with demand data.
The elasticity of intertemporal substitution in consumption, a key input into macroeconomic models, has been estimated by hundreds of researchers. Her devotion to the program is what enables all of us students to. The eis is arguably one of the most important parameters in economics as it plays a central role for a range of questions in macro, public. Thats why we call this type of utility functions the isoelastic utility function.
In many economic textbooks the constant elasticity of substitution ces utility function is defined as. Mathematically, this is a bivariate ces function so we know that the elasticity of substitution will be constant between the two arguments, whatever they are. That elasticity can be measured by the response of the. The intertemporal elasticity of substitution thus represents the proportional change in consumption that must follow to a one percent change in the interest rate in order to keep the.
Only in the case where the investment opportunity set is constant, is the optimal portfolio weight independent of the elasticity of intertemporal substitution, though even in this case the consumption decision depends on both risk aversion and elasticity of intertemporal substitution. Definition of intertemporal substitution econmodel. Elasticity of intertemporal substitution springerlink. In all common models of intertemporal allocation, the assumption of a constant elasticity of intertemporal substitution eis imposes surprising limitations on withinperiod budget allocations. This panel thus highlights the sensitivity of the speed of convergence to both the elasticity of substitution in production and the intertemporal elasticity of substitution. If intertemporal preferences are additive, the eis is constant, and within period preferences are not homothetic, then the intertemporal preference parameter is identified by the curvature of engel curves. Normalising ces production functions in the calibration of basic dynamic. Economic fluctuations and growth, public economics. Calibration is an effective tool for imposing discipline on the choice. Elasticity of intertemporal substitution journal of money and.
Lecture notes on elasticity of substitution ted bergstrom, ucsb economics 210a october 26, 2015 todays featured guest is \the elasticity of substitution. Highlights we estimate the elasticity of intertemporal substitution for the us economy. We present estimates of the elasticity of intertemporal substitution eis for iranian. We can now write the consumers problem as a dynamic program. The new legislation authorized banks to offer higher interest rates on deposits to citizens above 60 years of age. A taxbased estimate of the elasticity of intertemporal substitution jonathan gruber. In general, preferences over consumption bundles at different points in time should be represented by a utility function of the form 1. Thanks for contributing an answer to economics stack exchange. Elasticity of intertemporal substitution metaanalysis. Much of the literature that focuses on this parameter is based on the estimation of the firstorder conditions associated with intertemporal optimization the euler equation approach. Calibration and simulation of dsge models paul gomme. Estimating intertemporal and intratemporal substitutions when. This paper documents several advantages associated with using state level consumption data to examine consumption behavior and especially to estimate the intertemporal elasticity of substitution ies. The purpose of this paper is to present improved estimates of the intertemporal elasticity of substitution ies for japan assuming a constant relative risk aversion crra utility function.
If the real rate rises, current consumption may decrease due to increased return on savings. In the diagram, the wage path ii differs from path i in that there is a temporary wage increase at time t. Intertemporal labor supply university of hong kong. The intertemporal elasticity of substitution of consumption ies plays a key role in innumerable policy evaluations. Elasticity of intertemporal substitution in consumption in. A taxbased estimate of the elasticity of intertemporal. The inverse of the number is the intertemporal elasticity of substitution. Measuring intertemporal substitution metaanalysis in economics. Their estimates vary greatly, and it is unclear what values should be used for calibration.
Attanasio and weber 1995 find an elasticity of intertemporal substitution. For instance, with an intertemporal elasticity of substitution of 0. We considered the tbill, stocks, and a synthetic mutual fund returns. Havranek cnb, cuni elasticity of intertemporal substitution maernet, 11 sep 2015 3 21. Intertemporal substitution and hyperbolic discounting. Our findings have implications for the numerous calibration studies that rely on larger values of the.
Is the elasticity of intertemporal substitution constant. The elasticity of intertemporal substitution is defined as the percent change in consumption growth per percent increase in the net interest rate. Making the case for a low intertemporal elasticity of. These notches generate large bunching below the critical ltv thresholds and missing mass above them. Estimating the elasticity of intertemporal substitution using mortgage notches. Estimating the elasticity of intertemporal substitution. Production functions with a constant elasticity of substitution ces have been used extensively in.
An economic term describing how an individuals current decisions affect what options become available in the future. Furthermore, in contrast to the standard case of exponential discounting with isoelastic utility, the elasticity of intertemporal substitution for hyperbolic consumers depends on the duration of the change in the intertemporal relative price. The calibrated value of the eis is varied over a range of values used. On the intertemporal elasticity of substitution under nonhomothetic utility article in journal of money credit and banking 405. Most of our estimates suffer from the weak instrument problem. Alternative specifications for consumption and the estimation. Elasticity of intertemporal substitution or intertemporal elasticity of substitution is a measure of responsiveness of the growth rate of consumption to the real interest rate.
This panel thus highlights the sensitivity of the speed of convergence to both the elasticity of substitution in production and. Measuring the intertemporal elasticity of substitution for. The consumption tax, which is a value added tax vat, increased from three to five percent in april 1997. About intertemporal elasticity of substitution microeconomics. D12, d15, d84, e21 abstract we estimate the elasticity of intertemporal substitution eisthe response of expected. How ever, the use of micro data involves serious problems. A model economy is specified in which the modeler himself selects the intertemporal elasticity of substitution. Crossley and low is the elasticity of intertemporal substitution constant. Anton braun and tomoyuki nakajima working paper 20121 january 2012 abstract.
This dissertation estimates the elasticity of intertemporal substitution eis of con. It might at first seem that micro data provide a much firmer basis for estimating intertemporal substitution effects than do aggregate data. Estimates using tbill returns suggest that this elasticity is close to zero. The intertemporal elasticity of substitution between dates i and j is an evaluation of 2. Elasticity of intertemporal substitution is a measure of responsiveness of the growth rate of consumption to the real interest rate. The percentage difference in labor supply at time t on path i and labor supply at time t on path ii is d2. In this paper, we estimate the intertemporal elasticity of substitution in consumption ies using a rate increase in the japanese consumption tax as a natural experiment. The workhorse tool for the estimation of the eis is the loglinearized. The shape of the contour lines will look as follows. This paper documents several advantages associated with using state level consumption data to examine consumption behavior and especially to estimate the intertemporal elasticity of. Estimating the elasticity of intertemporal substitution using.
The elasticity of intertemporal substitution in consumption, a key input into. On the intertemporal elasticity of substitution under. Pdf measuring the intertemporal elasticity of substitution for. Our result provides a theoretical explanation for these empirical. Estimating the intertemporal substitution elasticity introduction the elasticity of intertemporal substitution eis, a key parameter in macroeconomics and nance, measures the sensitivity of expected consumption growth to the real interest rate ie the expected real return on a nominally riskfree asset. Intertemporal and intratemporal substitution, and the speed. Theoretically, by not consuming today, consumption. Making the case for a low intertemporal elasticity of substitution r. Then, using conventional statistical techniques, data generated from model simulations are used to estimate the elasticity. In recent papers macurdy 1981a,bl examines intertemporal substitution effects at the microeconometric level. The parameter is known as the elasticity of intertemporal substitution.
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