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Title:Reexamining the consumption-wealth relationship: The role of model uncertainty PDF Logo
Authors:Koop, Gary M.
Potter, Simon M.
Strachan, Rodney W.
Issue Date:2005
Series/Report no.:Staff Report, Federal Reserve Bank of New York 202
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.
Subjects:wealth effect, vector error correction model, Bayesian model averaging, cointegration, variance decomposition
JEL:C11
E21
Document Type:Working Paper
Appears in Collections:Staff Reports, Federal Reserve Bank of New York

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