DP8233 Estimating the Aggregate Consumption Euler Equation with State-Dependent Parameters

Author(s): Haroon Mumtaz, Paolo Surico
Publication Date: February 2011
Keyword(s): aggregate consumption, Euler equation, heterogeneity, state-dependence
JEL(s): E21, E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8233

The consumption Euler equation is a building block of modern macro theory. Yet, the existing evidence on aggregate data offers very conflicting results for the estimates of the degree of forward-lookingness and interest rate semi-elasticity. The disappointing performance can be rationalized by estimating an Euler equation in which the parameters are allowed to vary with the state of the economy. The nonlinear method reveals that during periods in which consumption is above its conditional average the estimates of the degree of forward-lookingness and interest rate semi-elasticity are significantly larger (in absolute value) than the estimates associated with periods of below-average consumption. Our evidence is consistent with models of state-dependence or heterogeneity in the discount factor and the elasticity of intertemporal substitution.