The Spirit of Capitalism and Excess Smoothness

In a recent paper [Luo, Smith, and Zou (2009)] we showed that the spirit of capitalism could in theory resolve the two fundamental anomalies of modern consumption theory, excess sensitivity and excess smoothness. However, that basic model could not plausibly explain the empirical magnitude of excess smoothness. In this paper we develop two extensions of the model ¡ª one with transitory and permanent shocks to income, the other with a stochastic interest rate ¡ª that where the spirit of capitalism can explain excess smoothness.