Academic journal article Journal of Economics and Finance

Parameter Interchangeability under Recursive Utility with Housing

Academic journal article Journal of Economics and Finance

Parameter Interchangeability under Recursive Utility with Housing

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1Introduction

Households invest part of their income and/or wealth to smooth consumption and insure against risk. The preference parameters are important in determination of consumption, savings and investment patterns, at both the household and the aggregate level. Equilibrium prices in the financial markets must also reflect the demands of investors which reflect their preferences. In macroeconomics, the elasticity of intertemporal substitution is essential for many questions ranging from the effects of monetary and fiscal policies to the determinants of long-run economic growth (King and Rebelo 1990; Jones et al. 2000). Intertemporal substitution affects the propagation mechanism in micro-founded business cycle models and determines the effectiveness of tax policies. Hall (1988) also states that intertemporal substitution is a central element of most modern macroeconomic models. The quantitative effects of changes in various policies depends on the intertemporal elasticity of substitution (EIS). The parameter of intertemporal substitution is one important determinant for consumption growth rate. Jones et al. (2000) conclude that whether uncertainty decreases economic growth rate depends on the degree of intertemporal substitution. Finally, the effectiveness of the interest rate, commonly used by central banks as a monetary policy instrument, also hinges on households willingness to substitute consumption across time.

In a deterministic economy, the elasticity of intertemporal substitutability measures (EIS) the extent to which consumption growth between two dates changes when the real interest rate between those dates changes. Thus, the elasticity of intertemporal substitutability controls the volatility of consumption growth when real interest rate is fluctuating. The elasticity of intertemporal substitutability (EIS) defines the degree of substitutability-complementarity between consumption today and the certainty equivalent of consumption tomorrow (CE(Ct+\)). If EIS ^ 0, consumption today and CE(Ct+\) become perfect complements. At the other extreme, if EIS ^ , then consumption today and CE(Ct+1) become perfect substitutes. Therefore, the parameter of intertemporal substitution defines the degree of substitutability-complementarity between consumption today and CE(Ct+1), and the time discount parameter parameterizes such a relation. With respect to the time discount parameter, the role of the parameter of intertemporal substitution is to determine the marginal rate of substitution between today's consumption consumption today and certainty equivalent of consumption tomorrow (CE(Ct+1)). The elasticity of intertemporal substitutability (EIS) also measures the desire for consumption smoothing across time.

The rate of time preference (RTP) or discount rate is also influential in shaping intertemporal consumption decisions. A discount rate in economics is related to the marginal rate of substitution between current and future consumption; it is the ratio of the marginal utility of one unit of consumption in the future to that in the present. The RTP measures the slope of the indifference curve between consumption at two adjacent dates with the same amount of consumption at both dates. The time discount parameter shows the degree at which the agent discounts future utility. The agent will value current consumption more and future consumption less with a lower discount rate. The discount rate has become one of the central concepts of finance and been investigated intensively in the economic literature.

Aydilek and Aydilek (2018) made sensitivity analysis using a recursive utility setting with housing. They found similarities on the effects of the changes in the parameters of intertemporal substitution and discount rate. We aim to explore the interchangeability of these two important parameters under recursive utility with housing, motivated by those similarities. …

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