TY - JOUR
T1 - Persistent vs. Permanent Income Shocks in the Buffer-Stock Model
AU - Druedahl, Jeppe
AU - Jørgensen, Thomas Høgholm
PY - 2017/1
Y1 - 2017/1
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
VL - 17
SP - 1
EP - 16
JO - B.E. Journal of Macroeconomics
JF - B.E. Journal of Macroeconomics
SN - 1935-1690
IS - 1
ER -