Estimating Sentiment and Risk in a Consumption Model: A Factor Analysis Approach

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Abstract/Contents

Abstract: 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 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. This offers the opportunity to exploit a data rich information base in assessing uncertainty shocks and changes in the dynamics of the state of the economy over time. 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 multi-component 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%. This suggests that channels of economic decisions relating to sentiment about the future and broader attitudes towards short-run and long-run risks are important features to be considered in analyzing dynamic stochastic economic models with recursive utility.

Type of resource	text
Date created	July 28, 2021

Subject	optimal consumption,
Subject	recursive utility
Subject	sentiment
Subject	short-run risk
Subject	long-run risk
Subject	latent factor analysis approach
Subject	democratic orthogonalization
Genre	Text
Genre	Working paper
Genre	Grey literature

DOI	https://doi.org/10.25740/tc741vm8696
Location	https://purl.stanford.edu/tc741vm8696

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License: This work is licensed under a Creative Commons Attribution 4.0 International license (CC BY).

Preferred citation: Bouaddi, M. and Kakeu, J. (2022). Estimating Sentiment and Risk in a Consumption Model: A Factor Analysis Approach. Stanford Digital Repository. Available at https://purl.stanford.edu/tc741vm8696

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