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

26 Pages Posted: 9 Jun 2016

See all articles by Jeppe Druedahl

Jeppe Druedahl

University of Copenhagen - Department of Economics

Thomas Jørgensen

University of Copenhagen

Date Written: June 2, 2016

Abstract

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 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.

Keywords: Persistent and permanent income shocks, imperfect markets life cycle model, simulated method of moments, marginal propensity to consume

JEL Classification: D31, D91, E21

Suggested Citation

Druedahl, Jeppe and Jørgensen, Thomas, Persistent vs. Permanent Income Shocks in the Buffer-Stock Model (June 2, 2016). Univ. of Copenhagen Dept. of Economics Discussion Paper No. 16-04, Available at SSRN: https://ssrn.com/abstract=2792581 or http://dx.doi.org/10.2139/ssrn.2792581

Jeppe Druedahl (Contact Author)

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

Thomas Jørgensen

University of Copenhagen ( email )

Nørregade 10
Copenhagen, København DK-1165
Denmark

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