Disentangling Intertemporal Substitution and Risk Aversion under the Expected Utility Theorem
AbstractA disturbing feature of the conventional objective function for intertemporal decisions under uncertainty is that the agent's attitudes toward intertemporal substitution and risk aversion are entangled. This paper shows that, in contrast to common perception, the two attitudes can be completely disentangled under the expected utility theorem (EUT) by modeling each of them successively in two steps. The conventional form is nested as a special case where the functions describing the two attitudes are identical. The proposed framework requires only the standard axioms of the EUT, in addition to a regulatory assumption. It is flexible in accommodating different combinations of the two attitudes, indifferent to the timing of resolution of uncertainty, intuitive to interpret, and extendable to multiple goods. The objective function under the proposed framework is time inconsistent according to Strotz's (1955) definition. I argue that Strotz's notion of time consistency is misguided. It is constructed based on a priori assumption that the agent should continuously forget history as time progresses. But this means the agent is either chronically amnesiac or self-contradictory. To be truly consistent, the agent should have one and only one objective function, determined at birth, throughout his entire life. As history unfolds, the agent updates his information set, but not his objective function.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 11482.
Date of creation: 06 Nov 2008
Date of revision:
Intertemporal substitution; Risk aversion; Expected utility theorem; Time consistency; Equity premium puzzle;
Find related papers by JEL classification:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- D91 - Microeconomics - - Intertemporal Choice - - - Intertemporal Household Choice; Life Cycle Models and Saving
- E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-11-18 (All new papers)
- NEP-MAC-2008-11-18 (Macroeconomics)
- NEP-UPT-2008-11-18 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Cochrane, John H. & Campbell, John, 1999.
"By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior,"
3119444, Harvard University Department of Economics.
- John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
- John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
- John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers, Center for Research in Security Prices, Graduate School of Business, University of Chicago 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Loewenstein, George & Prelec, Drazen, 1992. "Anomalies in Intertemporal Choice: Evidence and an Interpretation," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 107(2), pages 573-97, May.
- Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
- Martin J. Beckmann, 1959. "A Dynamic Programming Model of the Consumption Function," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 68, Cowles Foundation for Research in Economics, Yale University.
- Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
- Mehra, Rajnish & Prescott, Edward C., 1985.
"The equity premium: A puzzle,"
Journal of Monetary Economics, Elsevier,
Elsevier, vol. 15(2), pages 145-161, March.
- Constantinides, George M, 1990.
"Habit Formation: A Resolution of the Equity Premium Puzzle,"
Journal of Political Economy, University of Chicago Press,
University of Chicago Press, vol. 98(3), pages 519-43, June.
- G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
- Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 537-79, May.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Ekkehart Schlicht).
If references are entirely missing, you can add them using this form.