Working Paper no. 204
By Emilio Fernandez-Corugedo, Simon Price and Andrew Blake
Simple intertemporal consumption theory implies that non-durable consumption is a random walk, but that consumption cointegrates with income and wealth. By the Granger representation theorem, there must be a (vector) error correction mechanism ((V)ECM) representation of the data; but from the theory, the equilibrating ECM cannot be in consumption. Instead, even with generalisations such as habit persistence, this equilibration should take place via income or wealth. Furthermore, unless the relative price of durables and non-durables is constant, the relative price needs to be taken into account in modelling. In this paper, the short-run dynamics and long-run relationship between non-durable consumption, non-asset income, wealth and the relative price of durable goods are examined. A cointegrating relationship is found to exist. Estimating VECMs, it is found that the adjustment towards the long-run common trend does indeed occur partly via changes in wealth, consistent with forward-looking behaviour on the part of agents. The result implies that consumption will predict asset returns, and this is confirmed by a regression of excess equity returns on the lagged disequilibrium term. A decomposition of shocks hitting the system reveals that between 30% and 90% of fluctuations in non-human wealth are transitory. Even if the lower figure applies, this means a substantial part of short-term fluctuations in wealth is decoupled from permanent consumption.