A Re-examination of the Excess Smoothness Puzzle When Consumers Estimate the Income Process

Anurag Banerjee () and Parantap Basu

Journal of Forecasting, 2001, vol. 20, issue 5, 357-66

Abstract: The excess smoothness puzzle is explored using a simple version of the permanent income hypothesis. The new feature is that consumers do not know the observed data-generating process for income. Instead they estimate the income process every period using the past income data and update their income forecasts as new data arrive. Two scenarios are examined: first, where the income has a linear deterministic trend and second, where the income has a constant trend. There is a misspecification bias in the estimate of the marginal propensity to consume (MPC). This bias is of second-order importance in the first scenario while it is of first-order importance in the second. We conclude that the second scenario, which may be relevant for less developed countries, may offer a potential solution to the excess smoothness puzzle. Copyright © 2001 by John Wiley & Sons, Ltd.

Date: 2001
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Persistent link: https://EconPapers.repec.org/RePEc:jof:jforec:v:20:y:2001:i:5:p:357-66

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