Summary of WP/92/109
“The Volatility of Consumption in a Simple General Equilibrium Model” by Gunnar Tersman
This paper studies the volatility of consumption relative to output in a simple general equilibrium model of a small open economy subject to exogenous shocks in productivity. With infinite horizons and exogenous terms of trade, the model generates variance estimates that are typically well above those that can be observed in empirical data. The time-series process of consumption in empirical data, judged in this perspective, would thus seem “excessively smooth,” too stable to be consistent with intertemporal optimization. However, if one allows for finite horizons, broadly interpreted as liquidity constraints, the model is able to come up with more reasonable estimates.
Although finite horizons and endogenous terms of trade help in one dimension, by reducing the volatility of consumption relative to output, the model still fails to produce a plausible degree of serial correlation with respect to the consumption growth rate. The fact that the growth rate of consumption is positively correlated suggests that durability and adjustment costs are important aspects of consumption behavior. When these aspects are incorporated into the household’s decision problem, the model does well on both dimensions.