CONSUMPTION AND EXPECTED ASSET RETURNS: AN UNOBSERVED-COMPONENT APPROACH

Publisher: Cambridge University Press

E-ISSN: 1469-8056|19|5|1023-1044

ISSN: 1365-1005

Source: Macroeconomic Dynamics, Vol.19, Iss.5, 2014-01, pp. : 1023-1044

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Abstract

This paper proposes an unobserved-component approach to estimate expected returns on household assets and expected growth rates of excess consumption (consumption in excess of labor income) within a present-value model of consumption. The present-value model of consumption implies that the excess-consumption–assets ratio can be expressed as a function of the present discounted value of expected excess-consumption growth rate and expected asset returns. Because expected returns and expected excess-consumption growth rate are unobserved variables, we use an unobserved-component approach to extract them from the observed history of realized returns and excess-consumption growth rate. Our results suggest that both filtered returns and filtered excess-consumption growth rate are significant and better predictors of realized returns and realized excess-consumption growth rate than the one obtained by the lagged excess-consumption–assets ratio.