Risk and Growth: Theoretical Relationships and Preliminary Estimates for South Africa

In the recent literature on economic growth there is disagreement over the relationship between growth and volatility and their relative benefits and costs in welfare terms. An analytical resolution of this issue, which has serious implications for domestic and international development policies, has been seen to be contingent upon how relative risk aversion and intertemporal substitutability are related in frameworks characterizing utility maximization of representative agents. It is commonly assumed that these aspects of preferences are rigidly linked, casting doubt on the expected utility maximizing paradigm as an appropriate modeling methodology for analyzing this important issue. In this paper it is first shown that these concerns are only relevant for special functional forms that enforce a unitary consumption elasticity of wealth. Next, a theoretical approach is employed to specify a more general relationship between risk aversion and intertemporal substitutability. The theoretical model is developed in the context of a two country representative agent model where risk affects domestic and direct foreign investment in both countries. The two country orientation is also capable of interpretation of the relationship between one country and the rest of the world. In a preliminary empirical application of the methodology to South African data, we attempt estimation of the parameters of generalized functions for preferences and technology which are capable of distinguishing between risk aversion and intertemporal substitutability.