Measuring consumption smoothing in CEX data

Abstract

This paper proposes and implements a new method of measuring the degree of consumption smoothing using data from the Consumer Expenditure Survey. The structure of this Survey is such that estimators previously used in the literature are inconsistent, simply because income is measured annually and consumption is measured quarterly. We impose an AR(1) structure on the income process to obtain a proxy for quarterly income through a projection on annual income. By construction, this proxy gives rise to a measurement error which is orthogonal to the proxy itself - as opposed to the unobserved regressor - leading to a consistent estimator. We contrast our estimates with the output of two estimators used in the literature. We show that while the first (OLS) estimator tends to overstate the degree of risk sharing, the second (IV) estimator grossly understates it <br><br> Keywords; risk sharing, consumption smoothing, income risk, projection