Reexamining the Consumption-Wealth Relationship: The Role of Model Uncertainty

28 Pages Posted: 8 Mar 2005

See all articles by Simon Potter

Simon Potter

Peter G. Peterson Institute for International Economics

Gary Koop

University of Leicester - Department of Economics

Rodney W. Strachan

University of Queensland - School of Economics

Date Written: March 2005

Abstract

In their influential work on the consumption-wealth relationship, Lettau and Ludvigson found that while consumption responds to permanent changes in wealth in the expected manner, most changes in wealth are transitory with no effect on consumption. We investigate the robustness of these results to model uncertainty using Bayesian model averaging. We find that there is model uncertainty with regard to the number of cointegrating vectors, the form of deterministic components, lag length, and whether the cointegrating residuals affect consumption and income directly. Whether this uncertainty has important implications depends on the researcher's attitude toward this economic theory used by Lettau and Ludvigson. If we work with their exact model, our findings are very similar. However, if we work with a broader set of models, we find that the exact magnitude of the role of permanent shocks is difficult to estimate precisely. Thus, although some support exists for the view that the role of shocks is small, we cannot rule out the possibility that they have a substantive effect on consumption.

Keywords: wealth effect, vector error correction model, Bayesian model averaging, cointegration

JEL Classification: C11, E21

Suggested Citation

Potter, Simon and Koop, Gary M. and Strachan, Rodney W., Reexamining the Consumption-Wealth Relationship: The Role of Model Uncertainty (March 2005). Available at SSRN: https://ssrn.com/abstract=681290 or http://dx.doi.org/10.2139/ssrn.681290

Simon Potter (Contact Author)

Peter G. Peterson Institute for International Economics ( email )

1750 Massachusetts Avenue, NW
Washington, DC 20036
United States

Gary M. Koop

University of Leicester - Department of Economics ( email )

University Road
Leicester LE1 7RH
United Kingdom

Rodney W. Strachan

University of Queensland - School of Economics ( email )

Brisbane, QLD 4072
Australia

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