Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence
AbstractNo one has derived closed-form solutions for consumption with stochastic labor income and constant relative risk aversion utility. A numerical technique is used here to give an accurate approximation to the solution. The resulting consumption function is often dramatically different than the certainty equivalence solution typically used, in which consumption is proportional to the sum of financial wealth and the present value of expected future income. The results help explain three important empirical consumption puzzles: excess sensitivity of consumption to transitory income, high growth of consumption in the presence of a low risk-free interest rate, and underspending of the elderly. Copyright 1989, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
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Bibliographic InfoArticle provided by MIT Press in its journal Quarterly Journal of Economics.
Volume (Year): 104 (1989)
Issue (Month): 2 (May)
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Other versions of this item:
- Stephen Zeldes, . "Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence," Rodney L. White Center for Financial Research Working Papers 20-86, Wharton School Rodney L. White Center for Financial Research.
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