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The B.E. Journal of Macroeconomics

Editor-in-Chief: Cavalcanti, Tiago / Kambourov, Gueorgui

Ed. by Abraham, Arpad / Carceles-Poveda , Eva / Debortoli, Davide / Lambertini, Luisa / Nimark, Kristoffer / Schwartzman, Felipe / Wang, Pengfei

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Persistent vs. Permanent Income Shocks in the Buffer-Stock Model

Jeppe Druedahl / Thomas H. Jørgensen
Published Online: 2016-06-29 | DOI: https://doi.org/10.1515/bejm-2016-0035


We investigate the effects of assuming a fully permanent income shock in a standard buffer-stock consumption model, when the true income process is only highly persistent. This assumption is computationally very advantageous, and thus often used, but might be problematic due to the implied misspecification. Across most parameterizations, and using the method of simulated moments, we find a relatively large estimation bias in preference parameters. For example, assuming a unit root process when the true AR(1) coefficient is 0.97, leads to an estimation bias of up to 30 percent in the constant relative risk aversion (CRRA) coefficient. If used for calibration, misspecified preferences could, for example, lead to a serious misjudgment in the value of social insurance mechanisms. Economic behavior, such as the marginal propensity to consume (MPC), of households simulated from the estimated (misspecified) model is, on the other hand, rather close to that from the correctly specified model.

This article offers supplementary material which is provided at the end of the article.

Keywords: imperfect markets life cycle model; marginal propensity to consume; persistent and permanent income shocks; simulated method of moments

JEL Classification: D31; D91; E21


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About the article

Published Online: 2016-06-29

Citation Information: The B.E. Journal of Macroeconomics, Volume 17, Issue 1, 20160035, ISSN (Online) 1935-1690, ISSN (Print) 2194-6116, DOI: https://doi.org/10.1515/bejm-2016-0035.

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