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Estimating the elasticity of intertemporal substitution using mortgage notches

Best, Michael Carlos, Cloyne, James, Ilzetzki, Ethan and Kleven, Henrik Jacobsen (2019) Estimating the elasticity of intertemporal substitution using mortgage notches. Review of Economic Studies. ISSN 0034-6527

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Identification Number: 10.1093/restud/rdz025

Abstract

Using a novel source of quasi-experimental variation in interest rates, we develop a new approach to estimating the Elasticity of Intertemporal Substitution (EIS). In the UK, the mortgage interest rate features discrete jumps — notches — at thresholds for the loan-to-value (LTV) ratio. These notches generate large bunching below the critical LTV thresholds and missing mass above them. We develop a dynamic model that links these empirical moments to the underlying structural EIS. The average EIS is small, around 0.1, and quite homogeneous in the population. This finding is robust to structural assumptions and can allow for uncertainty, a wide range of risk preferences, portfolio reallocation, liquidity constraints, and optimization frictions. We also use our model to characterize the link between the EIS and the reduced-form borrowing elasticities often estimated in the literature. This analysis demonstrates that reduced-form elasticities are in general not informative of the underlying structural parameter as the translation between the two is mediated by endogenous variables that can vary widely across borrowers.

Item Type: Article
Official URL: https://academic.oup.com/restud
Additional Information: © 2018 Review of Economic Studies Ltd
Divisions: Economics
Subjects: H Social Sciences > HB Economic Theory
JEL classification: D - Microeconomics > D1 - Household Behavior and Family Economics > D14 - Personal Finance
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E40 - General
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Determination of Interest Rates; Term Structure of Interest Rates
D - Microeconomics > D1 - Household Behavior and Family Economics > D10 - General
H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H31 - Household
E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment > E21 - Macroeconomics: Consumption; Saving; Aggregate Physical and Financial Consumer Wealth
E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment > E20 - General
H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H30 - General
Sets: Departments > Economics
Date Deposited: 05 Jun 2018 14:46
Last Modified: 09 Nov 2019 00:03
URI: http://eprints.lse.ac.uk/id/eprint/88185

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