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

Jeppe Druedahl and Thomas Jørgensen
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Jeppe Druedahl: Department of Economics, University of Copenhagen

No 16-04, Discussion Papers from University of Copenhagen. Department of Economics

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 (search for similar items in EconPapers)
JEL-codes: D31 D91 E21 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2016-06-09
New Economics Papers: this item is included in nep-mac
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Journal Article: Persistent vs. Permanent Income Shocks in the Buffer-Stock Model (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:kud:kuiedp:1604

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