DP5054 The Time-Series Properties of Aggregate Consumption: Implications for the Costs of Fluctuations

Author(s): Ricardo Reis
Publication Date: May 2005
Keyword(s): consumption persistence, costs of fluctuations, models of aggregate consumption
JEL(s): E21, E32, E60
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5054

While this is typically ignored, the properties of the stochastic process followed by aggregate consumption affect the estimates of the costs of fluctuations. This paper pursues two approaches to modelling aggregate consumption dynamics and to measuring how much society dislikes fluctuations, one statistical and one economic. The statistical approach estimates the properties of consumption and calculates the cost of having consumption fluctuating around its mean growth. The paper finds that the persistence of consumption is a crucial determinant of these costs and that the high persistence in the data severely distorts conventional measures. It shows how to compute valid estimates and confidence intervals. The economic approach uses a calibrated model of optimal consumption and measures the costs of eliminating income shocks. This uncovers a further cost of uncertainty, through its impact on precautionary savings and investment. The two approaches lead to costs of fluctuations that are higher than the common wisdom, between 0.5% and 5% of per capita consumption.