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

Banerjee, A. N. and Basu, P. (2001) 'A re-examination of the excess smoothness puzzle when consumers estimate the income process.', Journal of forecasting., 20 (5). pp. 357-366.


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.

Item Type:Article
Additional Information:
Keywords:Sensitivity, Consumption, Excess smoothness forecast.
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Record Created:27 Aug 2008
Last Modified:08 Apr 2009 16:28

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