Estimating the Elasticity of Intertemporal Substitution When Instruments Are Weak

Motohiro Yogo

413 citations0/0 files storedThe Review of Economics and Statistics

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Monetary Policy and Economic Impact Financial Literacy, Pension, Retirement Analysis Economic theories and models

Abstract

In the instrumental variables (IV) regression model, weak instruments can lead to bias in estimators and size distortion in hypothesis tests. This paper examines how weak instruments affect the identification of the elasticity of intertemporal substitution (EIS) through the linearized Euler equation. Conventional IV methods result in an empirical puzzle that the EIS is significantly less than 1 but its reciprocal is not different from 1. This paper shows that weak instruments can explain the puzzle and reports valid confidence intervals for the EIS using pivotal statistics. The EIS is less than 1 and not significantly different from 0 for eleven developed countries.

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References

1985The equity premium: A puzzle 2005INTEREST AND PRICES: FOUNDATIONS OF A THEORY OF MONETARY POLICY 1989Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework 1977A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory 1991Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis 1988Intertemporal Substitution in Consumption 1983Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns 1996Finite-Sample Properties of Some Alternative GMM Estimators

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