Staff Reports
Reexamining the Consumption-Wealth Relationship:The Role of Model Uncertainty
March 2005Number 202
JEL classification: C11, E21

Authors: Gary Koop, Simon M. Potter, and Rodney W. Strachan

In their influential work on the consumption-wealth relationship, Lettau and Ludvigson found that while consumption responds to permanent changes in wealth in the expected manner, most changes in wealth are transitory with no effect on consumption. We investigate the robustness of these results to model uncertainty using Bayesian model averaging. We find that there is model uncertainty with regard to the number of cointegrating vectors, the form of deterministic components, lag length, and whether the cointegrating residuals affect consumption and income directly. Whether this uncertainty has important implications depends on the researcher's attitude toward this economic theory used by Lettau and Ludvigson. If we work with their exact model, our findings are very similar. However, if we work with a broader set of models, we find that the exact magnitude of the role of permanent shocks is difficult to estimate precisely. Thus, although some support exists for the view that the role of shocks is small, we cannot rule out the possibility that they have a substantive effect on consumption.

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For a published version of this report, see Gary Koop, Simon M. Potter, and Rodney W. Strachan, "Re-examining the Consumption-Wealth Relationship: The Role of Model Uncertainty," Journal of Money, Credit, and Banking 40, no. 2-3 (March/April 2008): 341-67.