A re-examination of the excess smoothness puzzle when consumers estimate the income process

Banerjee, Anurag N. and Basu, Parantap (2001) A re-examination of the excess smoothness puzzle when consumers estimate the income process. Journal of Forecasting, 20 (5), 357-366. (doi:10.1002/for.796).

Record type: Article

Abstract

The excess smoothness puzzle is explored using a simple version of the permanent income hypothesis. The new feature is that consumers do not know the observed data-generating process for income. Instead they estimate the income process every period using the past income data and update their income forecasts as new data arrive. Two scenarios are examined: first, where the income has a linear deterministic trend and second, where the income has a constant trend. There is a misspecification bias in the estimate of the marginal propensity to consume (MPC). This bias is of second-order importance in the first scenario while it is of first-order importance in the second. We conclude that the second scenario, which may be relevant for less developed countries, may offer a potential solution to the excess smoothness puzzle.

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