Academic journal article Journal of Money, Credit & Banking

Incomplete Intertemporal Consumption Smoothing and Incomplete Risk Sharing

Academic journal article Journal of Money, Credit & Banking

Incomplete Intertemporal Consumption Smoothing and Incomplete Risk Sharing

Article excerpt

EMPIRICAL STUDIES ON risk sharing--i.e., consumption smoothing across states of nature--have grown rapidly in recent years. The formal literature started by testing the null hypothesis of full risk sharing at various aggregation levels, such as among individuals in a village (Townsend 1994), among households (Altug and Miller 1990, Mace 1991, Cochrane 1991, Hayashi, Altonji, and Kotlikoff 1996), and among countries (Canova and Ravn 1996, Lewis 1996). These seminal papers, which were essentially based on regressions of consumption on income (and possibly on other idiosyncratic variables), often controlling for aggregate consumption, originated two strands of macroeconomic literature. One line of research--firmly based on theoretical foundations--has allowed for the possibility of incomplete risk sharing and has focused on its precise measurement (e.g., Obstfeld 1994, Crucini 1999, Crucini and Hess 2000, Athanasoulis and van Wincoop 2001). These studies usually focus on the degree of risk sharing across regions (mutual insurance across states of nature against idiosyncratic regional risks, ex ante) but typically pay less attention to the degree of intertemporal consumption smoothing of the region (diversification of idiosyncratic consumption across time, ex post). For example, Athanasoulis and van Wincoop (2001) have performed estimations of the degree of risk sharing, assuming away intertemporal consumption smoothing. Other risk-sharing studies have assumed an extreme degree of intertemporal consumption smoothing, either by taking the permanent income hypothesis to hold fully (Crucini 1999, Crucini and Hess 2000), or by postulating no intertemporal consumption smoothing altogether (Obstfeld 1994, 1995).

On the other side of the consumption literature, there is a well-known body of empirical work that employs intertemporal consumption smoothing (Hall 1978, Campbell and Deaton 1989, Campbell and Mankiw 1990, Deaton 1992, Ostergaard, Scrensen, and Yosha 2002). Among them, only a few studies (Sorensen and Yosha 2000, Bayoumi and Klein 1997) have investigated the degree of intertemporal consumption smoothing within a country versus across countries. Typically, this literature focuses on disposable income aggregates, thereby abstracting from the risk-sharing issue.

This paper links together these two major strands of the empirical consumption literature, by developing a method that jointly estimates the degree of risk sharing and the degree of intertemporal consumption smoothing. The empirical framework is consistent with both risk sharing and intertemporal consumption smoothing theory, Our methodology contributes to each of these previous lines of research. Existing methods of estimating risk sharing fail to allow for heterogeneity in the extent of intertemporal consumption smoothing. Conversely, investigations of intertemporal consumption choice typically ignore the risk-sharing dimension. By combining both dimensions in our empirical methodology, we provide a concrete assessment of the possible biases in each component of consumption choice arising from interactions between the two. This is particularly relevant in comparing country members of monetary unions and regions within countries. For example, much is made of the cost of monetary unification in terms of the loss of policy flexibility in responding to the inflationary pressure of business cycles. Yet a monetary union may enhance risk sharing among member countries by deepening financial linkages and by facilitating the development of federal fiscal institutions. Similarly, a monetary union also produces high correlation of inflation and nominal interest rates across time which is central to the intertemporal channel.

Using a data set updated up to 2004, we apply our method to three regions--the U.S. states, the OECD countries, and the EU members--in order to provide a possible rationalization for the failure of the full risk-sharing hypothesis by comparing intraversus inter-regional risk sharing and intertemporal consumption smoothing, and to shed light on the cost of the European monetary unification process. …

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