👍The Double Power Law in Consumption and Implications for Testing Euler Equations

In the fall of 2011, my Yale classmate Kieran told me about the paper Kocherlakota & Pistaferri (2009), which uses cross-sectional moments of household consumption to construct the stochastic discount factor and estimates the Euler equation of a consumption-based asset pricing model. Upon hearing the model description, I got skeptical about the econometric results because I knew size distributions for economic variables often have Pareto tails and hence high order moments may fail to exist. So we looked at the data and found that household consumption has Pareto tails with exponents about 3.5, which was problematic for the aforementioned paper because the authors used cross-sectional moments of order 5. Kieran and I wrote a comment and sent it to JPE. The comment was rejected, but the editor found our results interesting and encouraged us to submit a full paper.

We wrote the full paper in 2013. We are very lucky to get this paper published at JPE (which certainly helped me get tenure at UCSD). I later met both Kocherlakota and Pistaferri and neither of them were mad at me, so I appreciate their openmindedness for putting science above personal interest.