DP359 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, Risk Aversion|
|Programme Areas:||Applied Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=359|
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.