Reconciling Conflicting Evidence on the Elasticity of Intertemporal Substitution: A Macroeconomic Perspective

Abstract:     
This paper attempts to reconcile two opposing views about the elasticity of intertemporal substitution in consumption (EIS), a parameter that plays a key role in macroeconomic analysis. On the one hand, empirical studies using aggregate consumption data typically find that the EIS is close to zero (Hall, 1988). On the other hand, calibrated macroeconomic models designed to match growth and business cycle facts typically require that the EIS be close to one (Weil, 1989; Lucas, 1990). We show that this apparent contradiction arises from ignoring two kinds of heterogeneity across individuals. First, a large fraction of U.S. households do not participate in stock markets. Second, a variety of microeconomic studies using individual-level data conclude that an individual's EIS increases with his wealth. We study a dynamic macroeconomic model featuring these two realistic sources of heterogeneity which have been largely assumed away in macroeconomics to date. We find that limited participation creates substantial wealth inequality matching that in U.S. data. Consequently, the properties of aggregate variables directly linked to wealth, such as investment and output, are almost entirely determined by the (high-elasticity) stockholders. At the same time, since consumption is much more evenly distributed across households than is wealth, estimation using aggregate consumption uncovers the low EIS of the majority of households (i.e., the poor).

Keywords: Aggregate fluctuations, incomplete markets, wealth inequality, the elasticity of intertemporal substitution

JEL Classifications: E13, E21, E32, E44

Working Paper Series