This paper applies a factor model to the study of risk sharing among U.S. states. The factor model makes it possible to disentangle movements in output and consumption due to national, regional, or state-specific business cycles from those due to measurement error. The results of the paper suggest that some findings of the previous literature which indicate a substantial amount of interstate risk sharing may be due to the presence of measurement error in output. When measurement error is properly taken into account, the evidence points towards a lack of interstate smoothing.
JEL classification: E20, E32, F36
Key words: intranational business cycles, risk sharing, factor models
The author gratefully acknowledges financial support from ISFSE (CNR). The paper draws from the first chapter of the author’s Ph.D. dissertation at Yale University, and he thanks his advisor Christopher A. Sims for invaluable help. Comments by Charles Engel and two anonymous referees greatly helped to improve the paper. Suggestions by Stefan Krieger, Jacques Melitz, Francesc Obiols-Homs, Christopher Otrok, Bent Sorensen, and seminar participants at the 1999 Winter Meetings of the Econometric Society, the 1999 Midwest Macroeconomic Conference, and the 1999 Royal Economic Society Conference are also acknowledged. The author is also grateful to Alejandro Ponce R. for excellent research assistance. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.
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