Globally evolutionarily stable portfolio rules

The paper examines a dynamic model of a financial market with endogenous asset prices determined by short-run equilibrium of supply and demand. Assets pay dividends that are partially consumed and partially reinvested. The traders use fixed-mix investment strategies (portfolio rules), distributing their wealth between assets in fixed proportions. Our main goal is to identify globally evolutionarily stable strategies, allowing an investor to “survive,” i.e., to accumulate in the long run a positive share of market wealth, regardless of the initial state of the market. It is shown that there is a unique portfolio rule with this property—an analogue of the famous Kelly rule of “betting your beliefs.” A game theoretic interpretation of this result is given.     

The role of factor substitution in the theory of economic growth and income distribution: Two examples

While much empirical evidence suggests that the Cobb–Douglas production function may be a reasonable benchmark for aggregate analysis, we argue that the practice, particularly prevalent in contemporary growth theory, of adopting the Cobb–Douglas technology, may lead to misleading implications. Using two examples, we show that key implications of the models are highly sensitive to small deviations of the elasticity of substitution from unity. The first employs the standard neoclassical model and emphasizes the sensitivity of the speed of convergence to small changes in the elasticity of substitution. This in turn has profound consequences for wealth and income distribution. The second deals with foreign aid and highlights how the relative merits of “tied” versus “untied” aid are also very sensitive to the elasticity of substitution.     

Reexamining the permanent income hypothesis with uncertainty in permanent and transitory innovation states

In this paper, we reexamine the permanent income–consumption relationship analytically and empirically, based on the innovation regime-switching (IRS) model developed in [Kuan, C.M., Huang, Y.L., Tsay, R.S., 2005. An unobserved component model with switching permanent and transitory innovations. Journal of Business and Economic Statistics, 23, 443–454]. A novel feature of the IRS model is that it explicitly allows for uncertainty in innovation states. When the labor income follows an IRS process, it is shown that the agent’s perception on the likelihoods of income innovations being permanent and transitory plays a crucial role in determining the optimal forecasts on the change of consumption. The effect of a current labor income innovation on consumption is a weighted average of two distinct effects resulting from permanent and transitory innovations with the weights equal to the perceived likelihoods of the respective states. Also, past innovations may affect consumption when there are revisions in the perceived likelihoods of previous states. Our empirical study on US data shows that consumption indeed reacts significantly to the perceived likelihoods of innovation states. However, even after controlling for the effect of state uncertainty, we find consumption vastly underreacts to permanent innovations in labor income but reacts about the right magnitude to transitory ones when compared with the prediction of the permanent income hypothesis. This evidence is similar to [Elwood, S.K., 1998. Testing for excess sensitivity in consumption: A state-space unobserved components approach. Journal of Money, Credit, and Banking, 30, 64–82] but in sharp contrast with that found in [Hall, R.E., Mishkin, F.S., 1982. The sensitivity of consumption to transitory income: Estimates from panel data on households. Econometrica, 50, 461–480].     

Rational inattention,long-run consumption risk,and portfolio choice

This paper explores how the introduction of rational inattention (RI) – that agents process information subject to finite channel capacity – affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.     

Escaping Poverty: Risk-Taking and Endogenous Inequality in a Model of Equilibrium Growth

Recent macroeconomic models of income distribution generate equilibria characterized as poverty traps. These models specify a production indivisibility such that, due to problems of asymmetric information in credit or capital markets, poor agents are never able to acquire the resources necessary to overcome the indivisibility. In the context of an equilibrium growth model, this paper demonstrates that faced with such constraints, poor, risk-averse agents have incentives to voluntarily take on risk in the hopes of exiting poverty. Each period they remain in poverty, they sacrifice a small amount of current consumption to pool resources for this risky activity. Risk-taking, economic mobility, and the distribution of income are generated endogenously. Furthermore, beginning from identical endowments, “initial” inequality also emerges endogenously. It is shown that voluntary risk-taking eliminates many potential steady-state equilibria of this and other models—those that exhibit individual poverty traps. All agents (or dynasties) expect to escape at some future date, perhaps after an extended spell in poverty.     

Is consumption too smooth? The case of the United Kingdom

This study consider whether, for the UK, the restrictions of the rational expectations permanent income (REPI) model of consumption are consistent with the data and whether consumption is too smooth given innovations in labour income. Some of the findings confirm those for the USA: the REPI restrictions are rejected. However, in marked contrast to the result of Campbell and Deaton (1989), little is found to support the view that consumption is too smooth; indeed there is some support for the view that consumption is too volatile. Some insight is given as to how such results can arise.     

A reexamination of the consumption function using frequency domain regressions

This paper reexamines the permanent income hypothesis (PIH) in the frequency domain. In contrast to some time domain tests, our frequency domain approach provides an explicit and natural test ofboth the permanentand transitory implications of the PIH for jointly nonstationary consumption and income data. Using a simple theoretical model, we demonstrate that the PIH implies the marginal propensity to consume (MPC) out of zero frequency income is unity. The PIHalso implies that the theoretical MPC out of transitory (or high frequency) income is smaller than the long-run MPC. These theoretical restrictions are natural implications of Friedman's hypothesis that agents consume out of permanent or low frequency income and (dis)save out of transitory or high frequency income. We test this full set of restrictions directly using spectral regression techniques. Under our set of assumptions, the derived disposable income process is shown to have a unit root and to be cointegrated with consumption. We therefore employ a systems spectral regression procedure that accommodates stochastic trends in the consumption and income series as well as the joint dependence in these series. In view of the relatively recent development of these systems spectral estimators, we also conduct Monte Carlo simulations across both low and high frequencies to assess properties of the estimator relative to established single equation techniques. New empirical estimates of the consumption function and tests of the PIH based on systems spectral regression methods are reported for U.S. aggregate consumption and income data over the period 1948–1993. The empirical results provide some evidence for the theoretical implications of the PIH.     

Consumption Inequality in China: Theory and Evidence from the China Health and Nutrition Survey

We investigate consumption inequality in China both theoretically by constructing a theoretical model that delineates the transmission channels by which income shocks affect consumption and empirically through an Unequally Spaced Dynamic Panel Data model estimation. We find that China is experiencing consumption inequality with the full partial insurance of consumption against both permanent and transitory income shocks, although the impact of both types of shock are larger than the case of the United States. The results are due to precautionary savings motives of the Chinese. We further document how income becomes more dispersed in China and show how the family background of a child affects his outcome to a large extent. Policy implications based on our findings are proposed.     

Is man doomed to progress?

This paper is dedicated to the empirical exploration of the welfare effect of expectations and progress per se. Using 10 waves of the Russian Longitudinal Monitoring Survey (RLMS), a panel household survey rich in subjective variables, the analysis suggests that for a given total stock of inter-temporal consumption, agents are more satisfied with an increasing time profile of consumption: they seem to have a strong “taste for improvement”. This contributes to qualify the “Easterlin paradox” that income growth does not make people happy.     

Public capital, endogenous growth, and endogenous fluctuations

Cazzavillan [Cazzavillan, G., 1996. Public spending, endogenous growth, and endogenous fluctuations. Journal of Economic Theory 71, 394–415] studies a discrete-time, one-sector endogenous growth model with a flow of publicly enjoyable goods and productive services financed through income taxation. He demonstrates how equilibrium paths are indeterminate, for a large range of the consumption externality of public spending. This study extends [Cazzavillan, 1996] by considering an otherwise identical production function, except with public capital stock as an input. The results support the robustness of multiple growth paths even in a one-sector growth model with public capital stock, and modify the set of the consumption externality of public spending, in determining growth dynamics in a similar model with non-accumulated public spending.     

Labour participation of Arab women: estimates of the fertility to labour supply link

The standard theoretical framework for analysing households’ intertemporal decisions is the life-cycle/permanent income model. Among its implications, testing the model allows to analyse the response of consumption to fiscal policy. However, the empirical literature with microdata has yielded mixed results. This article examines the sensitivity of the results to the assumption of separability among goods and of homogeneity across households. For that purpose, we test a rational expectations permanent income model with household data drawn from the Spanish Family Expenditure Survey. This survey contains detailed information on total expenditure and the income presents large, exogenous quarterly changes due to an institutional feature. The article shows that assuming separability among commodities biases the test against the model. When separability is not imposed, we show that the rejection of the model depends on heterogeneity across households in terms of their members being unemployed or not. For those households permanently employed, the model cannot be rejected whatever their income status.     

BUFFER-STOCK SAVING AND HOUSEHOLDS' RESPONSE TO INCOME SHOCKS

We exploit information on the joint dynamics of household labor income, consumption, and wealth in the Italian Survey of Household Income and Wealth to structurally estimate a buffer-stock saving model. We compare the degree of consumption smoothing implied by the model to the corresponding empirical estimates based on the same data set. We estimate that Italian households smooth 12% of permanent income shocks in the data that is comparable to the model counterpart of 11% . This result contrasts with existing evidence, and our own findings in this article, of substantially more consumption smoothing in U.S. data.     

Health and infrastructure in a model of endogenous growth

This paper studies the optimal allocation of government spending between infrastructure and health (which affects labor productivity as well as household utility) in an endogenous growth framework. A key feature of the model is that infrastructure affects not only the production of goods but also the supply of health services. The rate of time preference is also endogenously related to health outcomes. The first part considers the case where health enters as a flow in production and utility, whereas the second focuses on a “stock” approach. Growth- and welfare-maximizing rules for income taxation and the allocation of public spending are derived.     

Scenarios and the growth of knowledge: Notes on the epistemic element in scenario building

Scenarios raise a very remarkable challenge. They are a special category of thought experiments and as such they deal with the domain of the “possible” and “probable”, i.e. with the world of speculation. Nevertheless they are of a crucial practical importance for public policy, management and strategic thinking in general: any premeditated significant action has to be preceded by such a thought experiment that anticipates the possibility of its outcomes and its implications. The question is then, how could speculation have such a crucial epistemic role? What kind of knowledge, if any, do scenarios produce? What is the epistemic role of scenarios? The objective of this article is to discuss the controversial but crucial issue of the epistemic functions of scenarios and to outline several possible approaches to it. The article explores the relevance in this respect of the research that has been already done on thought experiments, de-biasing, deductive arguments and uncertainty—and complexity—coping cognitive devices while indicating the potential contribution of that literature to the further development of the scenario building practice and of the futures methodology.     

Influence and inefficiency in the internal capital market

I model inefficient resource allocations in M-form organizations due to influence activities by division managers that skew capital budgets in their favor. Corporate headquarters receives two types of signals about investment opportunities: private signals that can be distorted by managers, and public signals that are undistorted but noisy. Headquarters faces a tradeoff between the cost of attaining an accurate private signal and the value of the information the signal provides. In contrast to existing models of “socialism” in internal capital markets, I show that investment sensitivity to Tobin's Q is higher than first-best in firms where division managers hold equity (a result consistent with evidence presented in Scharfstein, 1998). When managers face high private costs from distorting information (equity holdings), headquarters may commit to investment contracts that place “too little” weight on private signals and “too much” weight on public signals (i.e. Q). This result has implications for managers in the design of capital budgeting processes and incentive compensation systems.     

Permanent income hypothesis: An optimal control theory approach to a classical macro thesis

This paper investigates the extent by which the permanent income hypothesis (the normal income and the proportionality hypotheses) can be obtained by the optimal control approach with an explicit recognition of individual's rational behavior over time.     

Crowding out and crowding in: When does redistribution improve risk-sharing in limited commitment economies?

When the risk of default constrains financial contracts, public insurance policies can significantly affect private risk-sharing. This is because by changing income expectations and volatility, redistribution changes the attractiveness of default and thus endogenous borrowing constraints. Extending results by Krueger and Perri (2011) [8], this paper analyses the conditions under which redistribution can improve private insurance by making default less attractive to the income-rich, whose income it reduces. I first explain why public redistribution typically crowds out private insurance in the two-income economy, and identify the role of income persistence and saving after default. Second, I show how, in endowment economies with three income states or more and in economies with capital, redistributive taxes can improve, or “crowd in”, private consumption insurance. Finally, in a quantitative exercise using a realistic income process calibrated to US micro-data, moderate redistribution crowds in private insurance with production but not in an endowment economy.     

Topological games at Princeton, a mathematical memoir

The games of the title are “Nash” (or Hex), “Milnor” (or Y), “Shapley” (or Projective Plane) and “Gale” (or Bridg-It) all of which were discovered (or re-discovered) in Princeton in 1948–1949. After giving the basic topological connections, I will discuss more recent ramifications related to computational complexity theory. A recurrent theme will be non-constructive proofs, or how we can know something can be done without having the slightest idea of how to do it.     

Neoclassical life-cycle consumption: a textbook example

Summary.   We present a simple neoclassical life-cycle model in continuous time, in which the effects of endogenous labor supply, uncertain lifetime, and family composition on consumption and income profiles are jointly analyzed. Due to a parsimonious specification, analytical solutions for consumption growth are available for constant intertemporal elasticity of substitution preferences. Without relying on borrowing constraints, the model can generate a hump in the consumption profile, and a comovement of consumption and income during working life. Received: June 9, 1999; revised version: October 4, 1999     

Donations in a recursive dynamic model

Abstract.  This paper studies how donations respond to unexpected permanent changes in income and tax rates in a recursive dynamic model. The dynamic approach yields several interesting insights. If marginal tax rates are progressive, a permanent jump in a household's income increases its consumption and donations in the short run, but has no effect in the long run. The permanent income elasticity of current donations is likely to exceed one. If the marginal tax rate is flat, the jump in income raises consumption and donations in both the short and the long run. A permanent marginal tax rate cut raises consumption and donations in the long run if marginal tax rates are progressive, while it reduces donations in the short run if it has little direct impact on tax payments. If the marginal tax rate is flat, a tax cut has a positive effect on consumption in both the short and the long run, but has an ambiguous effect on donations.