IDEAS home Printed from https://ideas.repec.org/p/fth/pennfi/20-86.html
   My bibliography  Save this paper

Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence

Author

Listed:
  • Stephen Zeldes

Abstract

Those who study consumption behavior routinely assume that labor income is stochastic and that the utility function exhibits constant relative risk aversion. No one has derived closed form solutions to this problem, however, and therefore we do not know what the resulting consumption function looks like. In this paper, a numerical technique is used to give accurate approximations to the consumption function in multiperiod models with income uncertainty. The resulting consumption function is often dramatically different than the certainty equivalence solution typically used, in which consumption is proportional to the sum of financial wealth and the present discounted value of expected future labor income. The results help explain three important empirical consumption puzzles: the excess sensitivity of consumption to transitory income, the high growth of consumption in periods of low real interest rates, and the under spending of the elderly. In the last section of the paper, the numerical technique is applied to examples in which borrowing constraints are imposed. It is seen that future constraints, which bind only in certain states of the world, can have effects similar to those of current constraints that are binding.

Suggested Citation

  • Stephen Zeldes, "undated". "Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence," Rodney L. White Center for Financial Research Working Papers 20-86, Wharton School Rodney L. White Center for Financial Research.
  • Handle: RePEc:fth:pennfi:20-86
    as

    Download full text from publisher

    To our knowledge, this item is not available for download. To find whether it is available, there are three options:
    1. Check below whether another version of this item is available online.
    2. Check on the provider's web page whether it is in fact available.
    3. Perform a search for a similarly titled item that would be available.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    2. van den Bremer, Ton & van der Ploeg, Frederick & Wills, Samuel, 2016. "The Elephant In The Ground: Managing Oil And Sovereign Wealth," European Economic Review, Elsevier, vol. 82(C), pages 113-131.
    3. McCarthy, Jonathan, 1995. "Imperfect insurance and differing propensities to consume across households," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 301-327, November.
    4. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 237-255, September.
    5. Laurence Ball & David Romer, 1989. "Are Prices Too Sticky?," The Quarterly Journal of Economics, Oxford University Press, vol. 104(3), pages 507-524.
    6. R. Glenn Hubbard & Kenneth L. Judd, 1987. "Finite Lifetimes, Borrowing Constraints, and Short-Run Fiscal Policy," NBER Working Papers 2158, National Bureau of Economic Research, Inc.
    7. van den Bremer, Ton & van der Ploeg, Frederick & Wills, Samuel, 2016. "The Elephant In The Ground: Managing Oil And Sovereign Wealth," European Economic Review, Elsevier, vol. 82(C), pages 113-131.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fth:pennfi:20-86. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel). General contact details of provider: http://edirc.repec.org/data/rwupaus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.