Estimating sentiment and risk in a consumption model: a factor analysis approach

• Published in: Macroeconomic dynamics 2024-01, Vol.28 (1), p.249-275
• Main Authors: Bouaddi, Mohammed, Kakeu, Johnson
• Format: Article
• Language: English
• ISSN: 1365-1005; 1469-8056
• DOI: 10.1017/S1365100523000019

This empirical paper deals with the impacts of sentiment about the future, short-run risk, and long-run risk in a dynamic economic model of optimal consumption decisions with Schroder and Skiadas [(1999) Journal of Economic Theory 89, 68–126.] continuous-time stochastic recursive preferences. The empirical strategy combines both a latent factor method and a democratic orthogonalization technique. The latent factor method is applied to a large database of macroeconomic indicators, and a democratic orthogonalization technique is used to separate the relative importance of sentiment about the future and long-run risk channels in shaping optimal consumption decisions. The empirical results suggest that consumers with recursive preferences are not indifferent to long-run uncertainty shocks to future consumption prospects. Endogenous consumption variations are driven by a multicomponent mechanism, where on average, the sentiment component accounts for 15.33%, the short-run risk accounts for 16.89%, and the long-run risk pertains to 34.51%.