A FINANCE APPROACH TO ESTIMATING CONSUMPTION PARAMETERS

I. INTRODUCTION The idea of holding a portfolio rather than a single asset has been the focus of financial theory since its introduction by Markowitz in 1952. This Noble Prize-winning idea has been largely ignored in basic macroeconomic thinking and research and, especially, as it pertains to consumption economics. We think that the time is long overdue to feature a broad-based, highly diversified market rate of return in textbook and academic research. Our contribution is to show that substituting a market return for an interest rate, or any single variable, not only makes sense intuitively, but also potentially yields fruitful empirical results as well. We introduce a synthetic mutual fund (SMF), (1) with rate of return closely approximating the market return of finance theory, as the variable of choice. Something like it is clearly the variable chosen by rational households, directly or indirectly, as the vehicle of saving for retirement. On our calculation, it pays about 5% after taxes, after-inflation--its net real rate of return. No risk free or safe interest rate will do the job of providing adequately for retirement. To go beyond intuition, we use the SMF rate to estimate intertemporal elasticity of substitution (IES) and the coefficient of relative risk aversion (CRRA). Our estimates show less variability over selected time periods than any other estimates found in the literature. To achieve our objective, it was necessary to follow these steps: (1) define the SMF; (2) compute its net real rate of return from a long time series (48 yr) of data for the components that define it; (3) estimate econometrically the values for IES and CRRA for the whole time period and several shorter periods within it using previous model setups; and (4) compare our estimates with those from some well-known previous research. Our SMF includes money, treasury bills, intermediate and long-term government bonds, municipal tax-exempt bonds, corporate AAA bonds, common stocks, and residential real estate. We acknowledge Stambaugh's (1982) attempt to create a composite similar to the SMF in his response to Richard Roll's (1977) well-known argument that inferences based on the CAPM were invalid due to the impossibility of including all assets that define the market return. Stambaugh's market portfolio included stocks, bonds, residential real estate, household durables, and automobiles. Our "market" differs in several ways. Its inclusion of debt instruments is broader, and we do not include household durables or automobiles. More important, our computed rate of return is a net real return; his is nominal. His return to housing is based strictly on capital gain as measured by market value of the house. Ours include other elements of housing return such as implied rental income (and more) and capital gain is measured against equity in the house. He was interested in the CAPM; we are interested in consumption. Also, we note that our approach is strictly Markovian, or pre-CAPM. (2) There is no single tangency portfolio applicable to all investors. Markowitz (2005) restated his long-standing criticism of the CAPM recently. Our SMF is suggestive and easily computed. Others are possible. (3) The article proceeds as follows. Because of the stress we place on a portfolio and the net real rate of return, we include in Section II a brief account of the literature on the market measure of return and on the importance of taxation and inflation in calculating the real return on an asset. Section III is about data. There is a brief discussion on how we compute the rate of return on the SMF and present some useful descriptive statistics. In Section IV, we describe the simple Euler equation framework that underlies our work and a fairly conventional econometric model to be used in estimating IES and CRRA. In Section V, we present our results with discussion. This section constitutes the core of the article. Concluding remarks appear in Section VI. …