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

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  • van der Ploeg, Frederick

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 Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 359.

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Date of creation: Jan 1990
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Handle: RePEc:cpr:ceprdp:359

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Related research

Keywords: Consumption; Intertemporal Substitution; Risk Aversion;

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References

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  1. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
  2. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  3. Kimball, Miles S. & Mankiw, N. Gregory, 1989. "Precautionary Saving and the Timing of Taxes," Scholarly Articles 3443105, Harvard University Department of Economics.
  4. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
  5. Alberto Giovannini & Philippe Weil, 1989. "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Papers 2824, National Bureau of Economic Research, Inc.
  6. Kreps, David M & Porteus, Evan L, 1979. "Dynamic Choice Theory and Dynamic Programming," Econometrica, Econometric Society, vol. 47(1), pages 91-100, January.
  7. Campbell, John & Deaton, Angus, 1989. "Why Is Consumption So Smooth?," Scholarly Articles 3221494, Harvard University Department of Economics.
  8. repec:fth:harver:1421 is not listed on IDEAS
  9. Sandmo, Agnar, 1970. "The Effect of Uncertainty on Saving Decisions," Review of Economic Studies, Wiley Blackwell, vol. 37(3), pages 353-60, July.
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Cited by:
  1. Mark Huggett, 2004. "Precautionary Wealth Accumulation," Review of Economic Studies, Oxford University Press, vol. 71(3), pages 769-781.

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