Time-varying returns, intertemporal substitution and cyclical variation in consumption

Release date
Emmanuel De Veirman; Ashley Dunstan
Published as
de Veirman, Emmanuel and Ashley Dunstan (2011). ‘Time-varying returns, intertemporal substitution and cyclical variation in consumption’, The B.E. Journal of Macroeconomics, De Gruyter, Volume 11(1), Pages 1-41, DOI: https://doi.org/10.2202/1935-1690.1958.

This paper studies the importance of intertemporal substitution in consumption for the cyclical co-movement of consumption, net worth and income in New Zealand. We can largely explain the empirical hump-shaped consumption response to a transitory wealth increase by allowing for time-varying re- turns in an otherwise standard Permanent Income Hypothesis (PIH) model. At the net worth peak, households bring consumption forward in anticipation of low returns on saving. The PIH model fully explains the empirical response when households initially expect the net worth shock to be permanent, but gradually learn that it is in fact transitory.