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

Druedahl Jeppe () and Thomas Jørgensen ()
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Druedahl Jeppe: Department of Economics, University of Copenhagen, Øster Farimagsgade 5, Building 26, DK-1353 Copenhagen, Denmark, Website: http://econ.ku.dk/druedahl

The B.E. Journal of Macroeconomics, 2017, vol. 17, issue 1, 16

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 (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.

Keywords: imperfect markets life cycle model; marginal propensity to consume; persistent and permanent income shocks; simulated method of moments (search for similar items in EconPapers)
JEL-codes: D31 D91 E21 (search for similar items in EconPapers)
Date: 2017
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DOI: 10.1515/bejm-2016-0035

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