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The Volatility Trap; Precautionary Saving, Investment, and Aggregate Risk

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  • Reda Cherif
  • Fuad Hasanov

Abstract

We study the effects of permanent and temporary income shocks on precautionary saving and investment in a "store-or-sow" model of growth. High volatility of permanent shocks results in high precautionary saving in the safe asset and low investment, or a "volatility trap." Namely, big savers invest relatively little. In contrast, low volatility of permanent shocks leads to low precautionary saving and high or low investment, depending on the volatility of temporary shocks. Empirical evidence shows a nonlinear relationship between investment and saving and that investment is a hump-shaped function of the volatility of permanent shocks, as predicted by the model.

Suggested Citation

  • Reda Cherif & Fuad Hasanov, 2012. "The Volatility Trap; Precautionary Saving, Investment, and Aggregate Risk," IMF Working Papers 12/134, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:12/134
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    References listed on IDEAS

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    1. Durdu, Ceyhun Bora & Mendoza, Enrique G. & Terrones, Marco E., 2009. "Precautionary demand for foreign assets in Sudden Stop economies: An assessment of the New Mercantilism," Journal of Development Economics, Elsevier, vol. 89(2), pages 194-209, July.
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    3. Francois Gourio, 2012. "Disaster Risk and Business Cycles," American Economic Review, American Economic Association, vol. 102(6), pages 2734-2766, October.
    4. Cherif, Reda & Hasanov, Fuad, 2013. "Oil Exporters’ Dilemma: How Much to Save and How Much to Invest," World Development, Elsevier, vol. 52(C), pages 120-131.
    5. Borensztein, Eduardo & Jeanne, Olivier & Sandri, Damiano, 2013. "Macro-hedging for commodity exporters," Journal of Development Economics, Elsevier, vol. 101(C), pages 105-116.
    6. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, vol. 90(358), pages 314-329, June.
    7. Douglas Dacy & Fuad Hasanov, 2011. "A Finance Approach To Estimating Consumption Parameters," Economic Inquiry, Western Economic Association International, vol. 49(1), pages 122-154, January.
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    10. George-Marios Angeletos & Vasia Panousi, 2011. "Financial Integration, Entrepreneurial Risk and Global Imbalances," NBER Working Papers 16761, National Bureau of Economic Research, Inc.
    11. Park, Donghyun & Shin, Kwanho, 2009. "Saving, Investment, and Current Account Surplus in Developing Asia," ADB Economics Working Paper Series 158, Asian Development Bank.
    12. Luca A Ricci & Marcos Chamon & Yuanyan S Zhang, 2011. "Country Insurance Using Financial Instruments," IMF Working Papers 11/169, International Monetary Fund.
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    Cited by:

    1. Cherif, Reda & Hasanov, Fuad, 2013. "Oil Exporters’ Dilemma: How Much to Save and How Much to Invest," World Development, Elsevier, vol. 52(C), pages 120-131.
    2. Karim Barhoumi & Reda Cherif & Nooman Rebei, 2016. "Stochastic Trends, Debt Sustainability and Fiscal Policy," IMF Working Papers 16/59, International Monetary Fund.
    3. Mohey-ud-din, Ghulam & Siddiqi, Muhammad Wasif, 2013. "GDP Fluctuations and Private Investment: A Macro Panel Analysis of Selected South Asian Countries," MPRA Paper 60231, University Library of Munich, Germany, revised 15 Jun 2014.
    4. Araujo, Juliana D. & Li, Bin Grace & Poplawski-Ribeiro, Marcos & Zanna, Luis-Felipe, 2016. "Current account norms in natural resource rich and capital scarce economies," Journal of Development Economics, Elsevier, vol. 120(C), pages 144-156.

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