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Estimating Euler equations

Attanasio, O.P.; Low, H.; (2002) Estimating Euler equations. (IFS Working Papers W02/06). Institute for Fiscal Studies: London, UK. Green open access

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Abstract

In this paper we consider conditions under which the estimation of a log-linearized Euler equation for consumption yields consistent estimates of preference parameters. When utility is isoelastic and a sample covering a long time period is available, consistent estimates are obtained from the loglinearized Euler equation when the innovations to the conditional variance of consumption growth are uncorrelated with the instruments typically used in estimation. We perform a Montecarlo experiment, consisting in solving and simulating a simple life cycle model under uncertainty, and show that in most situations, the estimates obtained from the log-linearized equation are not systematically biased. This is true even when we introduce heteroscedasticity in the process generating income. The only exception is when discount rates are very high (e.g. 47% per year). This problem arises because consumers are nearly always close to the maximum borrowing limit: the estimation bias is unrelated to the linearization and estimates using nonlinear GMM are as bad. Across all our situations, estimation using a log-linearized Euler equation does better than nonlinear GMM despite the absence of measurement error. Finally, we plot life cycle profiles for the variance of consumption growth, which, except when the discount factor is very high, is remarkably flat. This implies that claims that demographic variables in log-linearized Euler equations capture changes in the variance of consumption growth are unwarranted.

Type: Working / discussion paper
Title: Estimating Euler equations
Open access status: An open access version is available from UCL Discovery
Publisher version: http://dx.doi.org/10.1920/wp.ifs.2002.0206
Language: English
Additional information: Please see http://eprints.ucl.ac.uk/15168/ and http://eprints.ucl.ac.uk/15169 for related items
UCL classification: UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS > Dept of Economics
URI: https://discovery.ucl.ac.uk/id/eprint/2960
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