Marginal vs. Average Bundle and the Intertemporal Elasticity of Substitution François Gourio ∗ December 2004 - Preliminary and Incomplete Abstract Saving an extra dollar means foregoing consumption today - but the consumption that you forego is not the average consumption good, rather it is a luxury that you trade off for a luxury later on. Hence, the price that affects the trade-off is not the price of the average consumption bundle (the CPI) but an index that overweighs luxury goods. Heterogeneity in goods leads thus to the presence of an additional term in the standard Euler equation. I compute this additional term and reestimate a simple Euler equation. In preliminary work, the correction appears minor: estimates of the IES are increased, but the absolute change in the estimated IES is small. 1 Introduction The estimation of consumption Euler equations has been at the forefront of macroeconomics and finance since Hall (1978) and Hansen and Singleton (1983). Estimating the intertemporal elasticity of substitution of consumption is important: this parameter determines, for instance, the speed of convergence of economies towards their steady-states, and the desirability of capital taxation. Most of the work in this literature has made the standard simplification that there is one good. (On top of the standard representative agent assumption.) However, conditions under which this aggregation over goods is possible are stringent: as will be demonstrated below, one needs to assume either homotheticity of preferences, i.e. that all income elasticities are unity, or that relative prices are constant. In this paper, I examine the consequences of relaxing both assumptions. I show that this results in the presence of an additional term in the usual log- linearized first-order condition. (This term reduces to zero either when all income elasticities ∗ Graduate Student, Dept of Economics, University of Chicago. Email: francois@uchicago.edu. I thank Casey Mulligan and Kevin Murphy for comments. The main point of this note is close to one Kevin Murphy made in his lectures. First draft, June 2003. 1