Euler Equation Estimation on Micro Data

Sule Alan, Kadir Atalay and Thomas Crossley ()

Koç University-TUSIAD Economic Research Forum Working Papers from Koc University-TUSIAD Economic Research Forum

Abstract: First order conditions from the dynamic optimization problems of consumers and firms are important tools in empirical macroeconomics. When estimated on micro-data these equations are typically linearized so standard IV or GMM methods can be employed to deal with the measurement error that is endemic to survey data. However, it has recently been argued that the approximation bias induced by linearization may be worse than the problems that linearization is intended to solve. This paper explores this issue in the context of consumption Euler equations. These equations form the basis of estimates of key macroeconomic parameters: the elasticity of inter-temporal substitution (EIS) and relative prudence. We numerically solve and simulate 6 different life-cycle models, and then use the simulated data as the basis for a series of Monte Carlo experiments in which we consider the validity and relevance of conventional instruments, the consequences of different data sampling schemes, and the effectiveness of alternative estimation strategies. The first-order Euler equation leads to biased estimates of the EIS, but that bias is perhaps not too large when there is a sufficient time dimension to the data, and sufficient variation in interest rates. A sufficient time dimension can only realistically be achieved with a synthetic cohort. Estimates are unlikely to be very precise. Bias will be worse the more impatient agents are. The second order Euler equation suffers from a weak instrument problem and offers no advantage over the first-order approximation.

Keywords: Euler Equations; Measurement Error; Instrumental Variables; GMM. (search for similar items in EconPapers)
JEL-codes: C20 E21 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2012-08
New Economics Papers: this item is included in nep-ecm and nep-mac
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Citations: View citations in EconPapers (5)

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Related works:
Journal Article: EULER EQUATION ESTIMATION ON MICRO DATA (2019)
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