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Durham University

Research & business

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Publication details for Dr Anurag Narayan Banerjee

Banerjee, A.N. & Basu, P. (2001). A re-examination of the excess smoothness puzzle when consumers estimate the income process. Journal of Forecasting 20(5): 357-366.

Author(s) from Durham


The excess smoothness puzzle is explored using a simple version of the permanent income hypothesis. The new feature is that consumers do not know the observed data-generating process for income. Instead they estimate the income process every period using the past income data and update their income forecasts as new data arrive. Two scenarios are examined: first, where the income has a linear deterministic trend and second, where the income has a constant trend. There is a misspecification bias in the estimate of the marginal propensity to consume (MPC). This bias is of second-order importance in the first scenario while it is of first-order importance in the second. We conclude that the second scenario, which may be relevant for less developed countries, may offer a potential solution to the excess smoothness puzzle.