Risk Aversion, Intertemporal Substitution and Consumption: the CARA-LQ Problem

Frederick (Rick) van der Ploeg

No 359, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper employs the recursive utility approach, based on quadratic felicity functions and constant absolute risk aversion, to distinguish between risk aversion and intertemporal substitution. Stochastic dynamic programming yields closed-loop linear decision rules for the CARA-LQ problem. Certainty equivalence no longer holds, but instead the decision maker plays a min-max strategy against nature. When applied to a life cycle consumption problem, one finds a rationale for precautionary saving and a larger sensitivity of changes in consumption to income innovations. It is also shown that consumers with Ricardian rationality can display a Keynesian propensity to consume out of a current tax cut.

Keywords: Consumption; Intertemporal Substitution; Risk Aversion (search for similar items in EconPapers)
Date: 1990-01
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Related works:
Working Paper: RISK AVERSION, INTERTEMPORAL SUBSTITUTION AND CONSUMPTION: THE CARA-LQ PROBLEM (1989)
Working Paper: Risk aversion, intertemporal substitution and consumption: The CARA-LQ problem (1989)
Working Paper: Risk aversion, intertemporal substitution and consumption: The CARA-LQ problem (1989)
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