Optimal consumption and savings with stochastic income and recursive utility

Chong Wang, Neng Wang and Jinqiang Yang

Journal of Economic Theory, 2016, vol. 165, issue C, 292-331

Abstract: We develop a tractable incomplete-markets model with an earnings process Y subject to permanent shocks and borrowing constraints. Financial frictions cause the marginal (certainty equivalent) value of wealth W to be greater than unity and decrease with liquidity w=W/Y. Additionally, financial frictions cause consumption to decrease with this endogenously determined marginal value of liquidity. Risk aversion and the elasticity of inter-temporal substitution play very different roles on consumption and the dispersion of w. Permanent earnings shocks, especially large discrete stochastic jumps, make consumption smoothing quantitatively difficult to achieve. Borrowing constraints and permanent discrete jump shocks can generate empirically plausible values for marginal propensities to consume in the range of 0.2 to 0.6.

Keywords: Buffer stock; Precautionary savings; Incomplete markets; Borrowing constraints; Permanent income; Non-expected utility; Marginal value of liquidity (search for similar items in EconPapers)
JEL-codes: E2 G11 G31 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (46)

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Related works:
Working Paper: Optimal Consumption and Savings with Stochastic Income and Recursive Utility (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:165:y:2016:i:c:p:292-331

DOI: 10.1016/j.jet.2016.04.002

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