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Abstract

In this paper, we address the issue of excess sensitivity/ smoothness of consumption purely from an estimation and forecasting point of view. Suppose the agent estimates the income process using the past income data and obtains best linear unbiased forecasts of future income and then she computes permanent income using these forecasts. How far will she be if she misspecies the income process as a trend stationary process when truly it is diference stationary? Using the recently developed sensitivity indices for forecasts, we argue that for a plausible characterization of the deterministic trend term in the income process, the mispecication bias for estimate of marginal propensity to consume is of second order importance.

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