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
JEL(s): 022, 921
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.