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The effects of uncertainty on optimal consumption

The effects of uncertainty on optimal consumption
The effects of uncertainty on optimal consumption
When marginal utility is convex and there is pure labour income uncertainty, certain results are well-known. Asset return uncertainty is often assumed to have qualitatively similar effects; see e.g. Skinner (1988). We show that this assumption is not correct. Asset return uncertainty gives rise to an additional term in the Euler equation, which by introducing a role for current cash-in-hand, may work in the opposite direction to the precautionary motive, leading to ambiguity in the slope of the expected consumption time profile. We present a linearised version of the Euler equation, and an associated closed form solution, in order to provide intuition for these results. Numerical analysis indicates that the approximation is reasonable for empirically plausible estimates of the variances of the underlying disturbances.
9907
Department of Economics, University of Southampton
Mason, R.
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Wright, S.
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Mason, R.
1a906445-3ab5-4208-a0fc-4df6e51a2b72
Wright, S.
7dc41855-33fc-45d2-ab05-94731436da96

Mason, R. and Wright, S. (1999) The effects of uncertainty on optimal consumption (Discussion Papers in Economics and Econometrics, 9907) Southampton, UK. Department of Economics, University of Southampton 34pp.

Record type: Monograph (Discussion Paper)

Abstract

When marginal utility is convex and there is pure labour income uncertainty, certain results are well-known. Asset return uncertainty is often assumed to have qualitatively similar effects; see e.g. Skinner (1988). We show that this assumption is not correct. Asset return uncertainty gives rise to an additional term in the Euler equation, which by introducing a role for current cash-in-hand, may work in the opposite direction to the precautionary motive, leading to ambiguity in the slope of the expected consumption time profile. We present a linearised version of the Euler equation, and an associated closed form solution, in order to provide intuition for these results. Numerical analysis indicates that the approximation is reasonable for empirically plausible estimates of the variances of the underlying disturbances.

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Published date: 30 June 1999

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Local EPrints ID: 33142
URI: http://eprints.soton.ac.uk/id/eprint/33142
PURE UUID: 9bafe2b2-1b1f-42f7-8ef5-6183a5c947da

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Date deposited: 10 May 2007
Last modified: 15 Mar 2024 07:42

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Contributors

Author: R. Mason
Author: S. Wright

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