Excess Volatility of Consumption in Developed and Emerging Markets: The Role of Durable Goods

We examine how much of the excess volatility of consumption puzzle in small open economies (Aguiar and Gopinath, JPE 2007) can be explained away by adding consumption of durable goods. Once we account for that, consumption is not as volatile as income for both developed and emerging market economies. However, the fact remains that consumption is still more volatile (relative to income) in emerging markets than in developed ones. We extend Aguiar and Gopinath's model of a small open economy with shocks to trend and cycle to include consumption of durable goods. Based on our simulations of a small open economy model with consumption of durable goods, we question the role for shocks to trend that have been previously documented in the literature.