Consumption And Expected Asset Returns: An Unobserved-Component Approach

This paper proposes an unobserved-component approach to estimate expected returns on household assets and expected growth rates of excess consumption (consumption in excess of labor income) within a present-value model of consumption. The present-value model of consumption implies that the excess-consumption–assets ratio can be expressed as a function of the present discounted value of expected excess-consumption growth rate and expected asset returns. Because expected returns and expected excess-consumption growth rate are unobserved variables, we use an unobserved-component approach to extract them from the observed history of realized returns and excess-consumption growth rate. Our results suggest that both filtered returns and filtered excess-consumption growth rate are significant and better predictors of realized returns and realized excess-consumption growth rate than the one obtained by the lagged excess-consumption–assets ratio.