Reconciling conflicting evidence on the elasticity of intertemporal substitution: A macroeconomic perspective

In this paper we reconcile two opposing views about the elasticity of intertemporal substitution (EIS). Empirical studies using aggregate consumption data typically find the EIS to be close to zero, whereas calibrated models designed to match growth and fluctuations facts typically require it to be close to one. This contradiction is resolved when two kinds of heterogeneity are acknowledged: one, the majority of households do not participate in stock markets; and two, the EIS increases with wealth. We introduce these two features into a standard real business cycle model. First, limited participation creates substantial wealth inequality as in the U.S. data. Consequently, the properties of aggregates directly linked to wealth (e.g., investment and output) are mainly determined by the (high-EIS) stockholders. Since consumption is much more evenly distributed than is wealth, estimation from aggregate consumption uncovers the low EIS of the majority (i.e., the poor). (c) 2006 Elsevier B.V. All rights reserved.