Robust Estimation of the Joint Consumption / Asset Demand Decision

The paper proposes an instrumental variables version of the Huber estimator as an alternative to the IV-Krasker Welsch estimator. The IV-Huber estimator is analytically and computationally much simpler than IV-Krasker Welsch. In the context of an empirical study of the importance of borrowing constraints on consumption, the paper reports the results for the following estimators: 1) conventional (non-robust) IV, 2) conventional IV after the subjective rejection of outliers, 3) conventional IV after trimming, 4) IV-Huber, and 5) IV-Krasker-Welsch. In the presence of a heavy-tailed error distribution, both the IV-Krasker Welsch and the IV-Huber estimators provide substantial improvements in efficiency over conventional IV. Further, the informal robust procedure of using conventional IV after trimming does not match the efficiency gains of the formal robust methods. The empirical results indicate that households exhibit incomplete smoothing of consumption, with about 20-50% of predictable movements in income being buffered by asset stocks. When saving is disaggregated by type of asset, the results provide some evidence of borrowing constraints: households which are not subject to a liquidity constraint use financial assets as their primary means of buffering income fluctuations, while constrained households use purchases of durable goods almost exclusively as the vehicle for consumption smoothing.

Excess Sensitivity of Consumption to Current Income: Liquidity Constraints or Myopia?

Almost all of the recent empirical tests of the rational expectations - permanent income hypothesis (RE-PIH) have rejected the hypothesis. The null hypothesis in this empirical literature typically consists of the joint hypothesis that 1) agents' expectations are formed rationally, 2) desired consumption is determined by permanent income, and 3) capital markets are"perfect" in the sense that agents can lend or borrow against expected future income at the same interest rate. This paper attempts to determine whether the excess sensitivity of consumption to current income can be attributed to a failure of the third component of the joint hypothesis -- the assumption of "perfect" capital markets -- as opposed to a failure of one or both of the first two assumptions. The paper examines, as a specific alternative to the PIH, a simple "Keynesian" consumption function in which the behavioral MPC out of transitory income is different from zero. Interpreting the unemployment rate as a proxy for the proportion of the population subject to liquidity constraints, the paper uses a generalized version of the econometric model in my earlier paper(1981) to conduct a specification test of the "Keynesian" consumption function. The finding that the estimate of the MPC out of transitory income is dramatically affected, in both magnitude and statistical significance, by the inclusion of the proxy for liquidity constraints suggests that liquidity constraints are an important part of the explanation of the observed excess sensitivity of consumption to current income.

A Model of Housing in the Presence of Adjustment Costs: A Structural Interpretation of Habit Persistence

The paper generalizes the Grossman and Laroque (1990) model of optimal consumption and portfolio allocation in the context in which a durable good (or house) subject to adjustment costs is both an argument of the utility function and a component of wealth. Because the Grossman and Laroque model abstracts completely from nondurable consumption, their analysis cannot address either a) the potential spillover effects of the adjustment costs of the durable good on the dynamics of nondurable consumption, or b) the implications for portfolio allocation of housing risk arising from variation in the relative price of housing. By introducing an endogenously determined but infrequently adjusted state variable, the housing model generates many of the implications of the habit persistence model, such as smooth nondurable consumption, state-dependent risk aversion, and a small elasticity of intertemporal substitution despite moderate risk aversion. Using a specification of the utility function which nests both the housing model and habit persistence, the Euler equation for nondurable consumption is estimated with household level data on food consumption and housing from the PSID. The habit persistence model (without housing effects) can be decisively rejected, while the housing model (without habit effects) is not rejected.

The Excess Smoothness of Consumption: Identification and Interpretation

The paper investigates the implications of the omitted information problem -- that is, the econometric problem which arises because an econometrician cannot explicitly include the complete set of variables potentially used by agents -- in the context of the "excess smoothness" phenomenon posed by Deaton 11987]. The paper shows that an econometrician who fails to take into account the effects of omitted information will incorrectly conclude that an empirical finding of excess smoothness of consumption implies that the income process is nonstationary. By contrast, with a more thorough understanding of the omitted information problem, the finding of excess smoothness of consumption is easily explained with two assumptions: a) the consumption data is generated by the excess sensitivity alternative hypothesis, in which consumption is a weighted average of current income and permanent income, and b) agents are forecasting on the basis of a larger information set than the econometrician. Further, excess smoothness is revealed to be consistent with a wide range of stationary income processes as well as nonstationary income processes. Thus the common presumption that the excess smoothness phenomenon is linked in an essential way to the stationarity or nonstationarity of the income process evaporates when omitted information is taken into consideration.

Owner-Occupied Housing and the Composition of the Household Portfolio Over the Life-Cycle

This paper studies the impact of the portfolio constraint imposed by the consumption demand for housing (the 'housing constraint') on the household's optimal holdings of financial assets. Since the ratio of housing to net worth declines as the household accumulates wealth, the housing constraint induces a life-cycle pattern in the portfolio shares of stocks and bonds. For reasonable degrees of risk aversion, the changes in portfolio composition over the life-cycle can be dramatic. For example, for a coefficient of relative risk aversion of 3, the ratio of stocks to net worth in the optimal portfolio is .09 for the youngest households (ages 18-30) and .60 for the oldest (age 70 and over). Using data from the PSID on home values to construct household level panel data on the real after-tax return to owner-occupied housing, as well as data on the returns to financial assets, the paper estimates the vector of expected returns and the covariance matrix for the set of assets consisting of housing, mortgages, stocks, Treasury bonds, and T-bills. Numerical methods are used to calculate the mean-variance efficient frontier, conditional on different values of the housing constraint, and the optimal portfolios associated with different levels of relative risk aversion.