Scandinavian Working Papers in Economics

Discussion Paper Series in Economics,
Norwegian School of Economics, Department of Economics

No 21/2018: Euler Equations, Subjective Expectations and Income Shocks

Orazio Attanasio (), Krisztina Molnar () and Agnes Kovacs ()
Additional contact information
Orazio Attanasio: University College London, Postal: London, UK
Krisztina Molnar: Dept. of Economics, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Economics, Helleveien 30, N-5045 Bergen, Norway
Agnes Kovacs: University of Manchester, Postal: Manchester, UK

Abstract: In this paper, we make three substantive contributions: first, we use elicited subjective income expectations to identify the levels of permanent and transitory income shocks in a life-cycle framework; second, we use these shocks to assess whether households' consumption is insulated from them; third, we use the shock data to estimate an Euler equation for consumption. We find that households are able to smooth transitory shocks, but adjust their consumption in response to permanent shocks, albeit not fully. The estimates of the Euler equation parameters with and without expectational errors are similar, which is consistent with rational expectations. We break new ground by combining data on subjective expectations about future income from the Michigan Survey with micro data on actual Income from the Consumer Expenditure Survey.

Keywords: life cycle models; estimating Euler Equations; survey expectations

JEL-codes: C13; D12; D84; D91; E21

48 pages, October 25, 2018

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