Working Paper: CEPR ID: DP359
Authors: Frederick van der Ploeg
Abstract: This paper employs the recursive utility approach, based on quadratic felicity functions and constant absolute risk aversion, to distinguish between risk aversion and intertemporal substitution. Stochastic dynamic programming yields closed-loop linear decision rules for the CARA-LQ problem. Certainty equivalence no longer holds, but instead the decision maker plays a min-max strategy against nature. When applied to a life cycle consumption problem, one finds a rationale for precautionary saving and a larger sensitivity of changes in consumption to income innovations. It is also shown that consumers with Ricardian rationality can display a Keynesian propensity to consume out of a current tax cut.
Keywords: risk aversion; intertemporal substitution; lifecycle hypothesis; precautionary saving; excess sensitivity; Ricardian consumers; Keynesian propensities to consume
JEL Codes: 020; 113; 213
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk aversion (D81) | increased saving behavior (D14) |
| uncertainty about future income (D89) | increased saving behavior (D14) |
| risk aversion and uncertainty about future income (D81) | precautionary saving (D14) |
| risk aversion and intertemporal substitution (D15) | saving decisions (D14) |
| tax cuts (H29) | consumption behavior (D10) |
| risk aversion (D81) | consumption sensitivity to income changes (D12) |