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Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model

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  • Zvi Bodie
  • Robert C. Merton
  • William F. Samuelson

Abstract

This paper examines the effect of the labor-leisure choice on portfolio and consumption decisions over an individual's life cycle. The model incorporates the fact that individuals may have considerable flexibility in varying their work effort (including their choice of when to retire). Given this flexibility, the individual simultaneously determines optimal levels of current consumption, labor effort, and an optimal financial investment strategy at each point in his life cycle. We show that labor and investment choices are intimately related. The ability to vary labor supply ex post induces the individual to assume greater risks in his investment portfolio ex ante. The model explains why the young (enjoying greater labor flexibility over their working lives) may take greater investment risks than the old. It also offers an explanation as to why consumption spending is relatively "smooth" despite volatility in asset prices. Finally, the paper provides a compact method for valuing the risky cash flows associated with future wage income.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3954.

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Date of creation: Jan 1992
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Publication status: published as Journal of Economic Dynamics and Control, Vol. 16 (July/October 1992).
Handle: RePEc:nbr:nberwo:3954

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