THE INTERTEMPORAL ELASTICITY OF SUBSTITUTION - AN EXPLORATION USING AUS PANEL OF STATE DATA

This paper uses state-level consumption data to estimate the intertemp oral elasticity of substitution of consumption (IES). In contrast to t he results of Hall (1988) and Campbell and Mankiw (1989), we provide e vidence indicating that the IES is significantly different from zero a nd probably close to one. Since inference about the IES in the context of the standard Euler equation is problematic as a result of mis-spec ification bias, we cast most of our discussion in the context of the f ramework developed by Campbell and Mankiw. This modifies the Euler equ ation in that a fraction of agents simply consume their income. The us e of panel data to examine the relationship between interest rates and consumption growth has two advantages. First, we achieve a significan t increase in precision, which in particular allows us to rule out a z ero IES. Second, we can use the panel aspect of the data to bypass ass et return measurement problems. In particular, we identify a common ti me component in expected consumption growth that is associated with mo vements in interest rates when the IES is positive.