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Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion

  • Joshua Aizenman

Developing countries use various risk reduction schemes, ranging from active management of buffer stocks and international reserves to commodity stabilization funds. The purpose of this paper is to reexamine the design of these schemes in a generalized expected utility maximization model where agents are disappointment averse. We derive first the generalized risk premium, showing that disappointment aversion increases the conventional risk premium by a term proportional to the standard deviation times the degree of disappointment aversion. Next, we show that disappointment aversion modifies the characteristics of precautionary saving. The concavity of the marginal utility continues to determine precautionary saving, but its effect is of a second order magnitude (proportional to the variance) compared to the first order effect (proportional to the standard deviation) induced by disappointment aversion. Hence, higher volatility increases the precautionary saving of a disappointment averse agent. This result applies even if the income process approaches a random walk. Finally, we reexamine the optimal size of buffer stocks, showing that disappointment aversion increases its size by a first order magnitude. A buffer stock that is rather small when agents are maximizing the conventional expected utility is rather large when agents are disappointment averse.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5361.

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Date of creation: Nov 1995
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Publication status: published as Journal of International Money & Finance, Vol. 17 (1998): 931-947.
Handle: RePEc:nbr:nberwo:5361
Note: ITI
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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  1. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
  2. Uzi Segal & Avia Spivak, 1988. "First Order Versus Second Order Risk Aversion," UCLA Economics Working Papers 540, UCLA Department of Economics.
  3. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
  4. Joshua Aizenman, 1995. "Investment in New Activities and the Welfare Cost of Uncertainty," NBER Working Papers 5041, National Bureau of Economic Research, Inc.
  5. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
  6. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
  7. Sandmo, Agnar, 1970. "The Effect of Uncertainty on Saving Decisions," Review of Economic Studies, Wiley Blackwell, vol. 37(3), pages 353-60, July.
  8. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  9. Newbery, David M, 1989. "The Theory of Food Price Stabilisation," Economic Journal, Royal Economic Society, vol. 99(398), pages 1065-82, December.
  10. Arrau, Patricio & Claessens, Stijn, 1992. "Commodity stabilization funds," Policy Research Working Paper Series 835, The World Bank.
  11. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  12. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
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