Discussion Paper Details

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Title: Risk Aversion, Intertemporal Substitution and Consumption: the CARA-LQ Problem

Author(s): Frederick van der Ploeg

Publication Date: January 1990

Keyword(s): Consumption, Intertemporal Substitution and Risk Aversion

Programme Area(s): Applied Macroeconomics

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.

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Bibliographic Reference

van der Ploeg, F. 1990. 'Risk Aversion, Intertemporal Substitution and Consumption: the CARA-LQ Problem'. London, Centre for Economic Policy Research.