Working Paper: NBER ID: w24948
Authors: Michael Carlos Best; James Cloyne; Ethan Ilzetzki; Henrik Kleven
Abstract: Using a novel source of quasi-experimental variation in interest rates, we develop a new approach to estimating the Elasticity of Intertemporal Substitution (EIS). In the UK, the mortgage interest rate features discrete jumps – notches – at thresholds for the loan-to-value (LTV) ratio. These notches generate large bunching below the critical LTV thresholds and missing mass above them. We develop a dynamic model that links these empirical moments to the underlying structural EIS. The average EIS is small, around 0.1, and quite homogeneous in the population. This finding is robust to structural assumptions and can allow for uncertainty, a wide range of risk preferences, portfolio reallocation, liquidity constraints, present bias, and optimization frictions. Our findings have implications for the numerous calibration studies that rely on larger values of the EIS.
Keywords: Elasticity of intertemporal substitution; Mortgage notches; Interest rates; Household finance; UK mortgage market
JEL Codes: D1; D14; D15; E2; E21; E4; E43; H3; H31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest rate notches (E43) | Borrowing behavior adjustment (G51) |
| Borrowing behavior adjustment (G51) | Elasticity of intertemporal substitution (EIS) (D15) |
| Optimization frictions (C61) | Elasticity of intertemporal substitution (EIS) estimate (D15) |
| Observed bunching at interest notches (E43) | Elasticity of intertemporal substitution (EIS) (D15) |