Elasticity of Intertemporal Substitution in Consumption in the Presence of Inertia: Empirical Evidence from a Natural Experiment

This paper estimates the elasticity of intertemporal substitution in consumption (sigma) by exploiting a natural experiment provided by a change in the Indian banking legislation. The new legislation authorized banks to offer higher interest rates on deposits to citizens above 60 years of age. We find evidence that households exhibit inertia in reoptimization and are sensitive to the timing of the actual change in the interest rate. Households do not respond to the predictable changes in future interest rates induced by the change in the legislation. We incorporate this and estimate the sigma to be approximately equal to 2.2.