1. What is cointegration? Why should consumption and income be cointegrated? Why should stock prices and dividends be cointegrated?
Cointegration is when two or more series of data feature trends individually, however when combined linearly they are stationary. Consumption and income should be cointegrated as over time the consumption to GNP ratio is relatively stable over long periods of time. This can also be seen with stock prices and dividend ratios, and once combined the variables can be considered stationary.
2. What is the point of the paper?
Cochrane contends that the consumption to GNP ratio can be used to forecase GNP growth. Consumption is nearly a random walk, and if consumption remains unchanged any change in GNP can almost entirely be considered a transitory change. This is the same in relation to the dividend to price ratio where should dividends remain unchanged, changes in price are almost entirely transitory.
3. What do you make of an increase in stock prices without a corresponding increase in dividends? Is it likely to be permanent or transitory? Why?
A market price should equal the sum of all future dividends, taking into account the time value of money. An increase in the stock price in the absence of an increase in dividends would likely be a transitory change unless an increase to the future value of dividends if foreseeable in the future. It could however be the case that in the short term investors do not expect dividends to rise as perhaps short term profits are not expected to increase. This could be prompted by a company favouring growth in a market share strategy instead, which is projected to result in increased future profits at the expense of short term profits, leading to short term dividends not seeing growth while future dividends benefit. This is plausible should a situation arise where stock price rise while dividends are stationary.
4. What do you make of a drop in GDP that is accompanied by a fall in consumption? Is it likely to be a permanent or transitory shock?
A drop in GDP which is accompanied by a fall in consumption is due to consumers factoring in that their situation is less prosperous than it was previously. This is not merely a transitory shock but a permanent shock that will result in them being able to consume less in the future.
5. What does Cochrane mean by saying that consumption defines the trend in GDP?
Cochrane states that consumption provides a good measure of the trend in GNP, since it measures consumers’ expectations of long-run GNP. This trend in GNP is GNP + all expected future GNP. This expected future GNP can be directly correlated to consumption, thus consumption is a good measure of trend in GDP.