Housing, adjustment costs, and macro dynamics

Abstract

When utility depends on a single, frictionlessly adjustable consumption good, the household's willingness to substitute consumption intertemporally is solely determined by the curvature of the utility function. When the utility specification is generalized from one good to two, however, the curvature parameter then specifies the curvature of the utility function with respect to a composite good. If both goods are frictionlessly adjustable, then each of the individual goods will all have the same dynamics, and the intuition from the one-good case-that the elasticity of intertemporal substitution is determined solely by the curvature parameter-remains valid. In this article, however, the two goods are interpreted as housing services and non-housing goods. Non-housing consumption can be adjusted frictionlessly, but housing services are subject to a non-convex adjustment cost. The article explores the dynamic behavior of non-durable consumption by solving numerically for the optimal level of non-housing consumption, conditional on an assumed path for housing consumption and for the marginal utility of wealth. The results indicate that the intertemporal behavior of nonhousing consumption depends crucially on the intratemporal substitutability of the two goods as well as the curvature of the utility function with respect to the composite good. © The Author 2011. Published by Oxford University Press on behalf of Ifo Institute for Economic Research, Munich. All rights reserved.