Re-examining the consumption-wealth relationship: the role of model uncertainty

Gary Koop, Simon M. Potter, Rodney W. Strachan

Research output: Working paper

Abstract

This paper discusses the consumption-wealth relationship. Following the recent influential workof Lettau and Ludvigson [e.g. Lettau and Ludvigson (2001), (2004)], we use data on consumption, assets andlabor income and a vector error correction framework. Key …ndings of their work are that consumption doesrespond to permanent changes in wealth in the expected manner, but that most changes in wealth are transitoryand have no e¤ect on consumption. We investigate the robustness of these results to model uncertainty andargue for the use of Bayesian model averaging. We …nd that there is model uncertainty with regards to thenumber of cointegrating vectors, the form of deterministic components, lag length and whether the cointegratingresiduals a¤ect consumption and income directly. Whether this uncertainty has important empirical implicationsdepends on the researcher's attitude towards the economic theory used by Lettau and Ludvigson. If we workwith their model, our findings are very similar to theirs. However, if we work with a broader set of models andlet the data speak, we obtain somewhat di¤erent results. In the latter case, we …nd that the exact magnitudeof the role of permanent shocks is hard to estimate precisely. Thus, although some support exists for the viewthat their role is small, we cannot rule out the possibility that they have a substantive role to play.
LanguageEnglish
Number of pages28
Publication statusPublished - Feb 2005

Fingerprint

Wealth
Model uncertainty
Income
Robustness
Economic theory
Assets
Bayesian model averaging
Permanent shock
Vector error correction
Lag
Uncertainty

Keywords

  • wealth effect
  • vector error correction model
  • Bayesian model
  • cointegration
  • variance
  • decomposition
  • econometrics

Cite this

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abstract = "This paper discusses the consumption-wealth relationship. Following the recent influential workof Lettau and Ludvigson [e.g. Lettau and Ludvigson (2001), (2004)], we use data on consumption, assets andlabor income and a vector error correction framework. Key …ndings of their work are that consumption doesrespond to permanent changes in wealth in the expected manner, but that most changes in wealth are transitoryand have no e¤ect on consumption. We investigate the robustness of these results to model uncertainty andargue for the use of Bayesian model averaging. We …nd that there is model uncertainty with regards to thenumber of cointegrating vectors, the form of deterministic components, lag length and whether the cointegratingresiduals a¤ect consumption and income directly. Whether this uncertainty has important empirical implicationsdepends on the researcher's attitude towards the economic theory used by Lettau and Ludvigson. If we workwith their model, our findings are very similar to theirs. However, if we work with a broader set of models andlet the data speak, we obtain somewhat di¤erent results. In the latter case, we …nd that the exact magnitudeof the role of permanent shocks is hard to estimate precisely. Thus, although some support exists for the viewthat their role is small, we cannot rule out the possibility that they have a substantive role to play.",
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Re-examining the consumption-wealth relationship : the role of model uncertainty. / Koop, Gary; Potter, Simon M.; Strachan, Rodney W.

2005.

Research output: Working paper

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