Estimating the Intertemporal Substitution Elasticity

37 Pages Posted: 16 Feb 2009

Date Written: February 16, 2009

Abstract

We estimate the intertemporal substitution elasticity (EIS) under a simple proxy method and instrument variable (IV) methods, addressing the seasonality effect, wealth-related fluctuation in relative risk aversion (RRA), and the time aggregation problem. The empirical tests are based on the pooled data consisting of 24 countries and two sub-samples, namely, continental European and emerging countries. The proxy method generates theoretically unacceptable negative EIS everywhere and its underlying assumption of martingale inflation is rejected. TSLS does hardly better, but GMM produces significantly positive EIS estimates. Enriching the regression equation with consumption seasonals and effects from asset markets - modeled as both main effects and interactions with the real interest rate, as theory suggests - again produces significantly positive, and higher, EIS. The resulting RRA, 1 to 4, chimes well with the numbers found in unconditional market-portfolio studies within a mean-variance framework.

Keywords: seasonality, inflation rate, instrumental variable, time aggregation, varying relative risk aversion

JEL Classification: G12, F43

Suggested Citation

Liu, Fang and Sercu, Piet M. F. A., Estimating the Intertemporal Substitution Elasticity (February 16, 2009). Available at SSRN: https://ssrn.com/abstract=1344231 or http://dx.doi.org/10.2139/ssrn.1344231

Fang Liu (Contact Author)

KU Leuven ( email )

Oude Markt 13
Leuven, Vlaams-Brabant 3000
Belgium

Piet M. F. A. Sercu

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

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