Understanding Trend and Cycle in Asset Values: Bulls, Bears and the Wealth Effect on Consumption

Martin Lettau and Sydney Ludvigson

No 3104, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This Paper uses restrictions implied by cointegration to identify the permanent and transitory elements (the ?trend? and ?cycle?) of household asset wealth. Our empirical analysis yields answers to the following questions: 1. Is there a large transitory component in household net worth or is wealth close to a random walk? Our point estimates imply that a striking 85% of the post-war variation in the growth of household net worth is transitory, attributable to fluctuations in the stock market component of wealth. Transitory wealth shocks are quite persistent, affecting asset values for a number of years. This transitory element picks out the ?bull markets? of the late 1960s and 1990s, and the ?bear? markets of the 1970s. If markets are efficient, these transitory fluctuations must be attributable to time-variation in the required rate of return on assets (discount rates). 2. How is transitory variation in household net worth related to consumer spending? Does consumption adapt with a lag to permanent movements in wealth? Despite their quantitative importance, transitory fluctuations in asset values are found to be unrelated to aggregate consumer spending. Instead, aggregate consumption can be well described as a function of the trend components in wealth and income. We find no evidence that consumption adapts with a long lag to fluctuations in wealth. 3. What kinds of shocks govern the dynamic behaviour of consumption, asset wealth and labour income? We characterize three: a permanent income shock that affects consumption, asset wealth and labour earnings without distorting their long-run equilibrium relation; an income redistributive shock that shifts the composition of income between labour and capital; and a discount rate shock that generates transitory variation in asset values.

Keywords: Wealth effect; Cointegration; Consumption; Asset values (search for similar items in EconPapers)
JEL-codes: E21 E44 G10 (search for similar items in EconPapers)
Date: 2001-12
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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