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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. Journal of Monetary Economics 22, 237–255). 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.
0165-1889
185-212
Mason, Robin
c989f0e0-de54-495d-aeaf-75b42d62cb61
Wright, Stephen
a47493e3-7d5a-4dcd-856f-8f38f21b80f4
Mason, Robin
c989f0e0-de54-495d-aeaf-75b42d62cb61
Wright, Stephen
a47493e3-7d5a-4dcd-856f-8f38f21b80f4

Mason, Robin and Wright, Stephen (2001) The effects of uncertainty on optimal consumption. Journal of Economic Dynamics and Control, 25 (1-2), 185-212. (doi:10.1016/S0165-1889(99)00073-1).

Record type: Article

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. Journal of Monetary Economics 22, 237–255). 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: 2001

Identifiers

Local EPrints ID: 33434
URI: http://eprints.soton.ac.uk/id/eprint/33434
ISSN: 0165-1889
PURE UUID: dade8bc7-67b1-43d7-8ee7-dbcb2e943256

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Date deposited: 16 May 2006
Last modified: 15 Mar 2024 07:44

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Author: Robin Mason
Author: Stephen Wright

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