Risk Aversion, Intertemporal Substitution and Consumption: the CARA-LQ Problem
AbstractThis 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 InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 359.
Date of creation: Jan 1990
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Other versions of this item:
- Van Der Ploeg, F., 1989. "Risk Aversion, Intertemporal Substitution And Consumption: The Cara-Lq Problem," Papers 8953, Tilburg - Center for Economic Research.
- Ploeg, F. van der, 1989. "Risk aversion, intertemporal substitution and consumption: The CARA-LQ problem," Discussion Paper 1989-53, Tilburg University, Center for Economic Research.
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