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Insuring Consumption Using Income-Linked Assets

48 Pages Posted: 9 Mar 2010  

Andreas Fuster

Federal Reserve Banks - Federal Reserve Bank of New York

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: February 24, 2010

Abstract

Shiller (2003) and others have argued for the creation of financial instruments that allow households to insure risks associated with their lifetime labor income. In this paper, we argue that while the purpose of such assets is to smooth consumption across states of nature, one must also consider the assets' effects on households' ability to smooth consumption over time. We show that consumers in a realistically calibrated life-cycle model would generally prefer income-linked loans (with a rate positively correlated with income shocks) to an income-hedging instrument (a limited liability asset whose returns correlate negatively with income shocks) even though the assets offer identical opportunities to smooth consumption across states. While for some parameterizations of our model the welfare gains from the presence of income-linked assets can be substantial (above 1 percent of certainty-equivalent consumption), the assets we consider can only mitigate a relatively small part of the welfare costs of labor income risk over the life cycle.

Keywords: Income Risk, Risk Sharing, Portfolio Choice, Financial Innovation

JEL Classification: D91, E21, G11

Suggested Citation

Fuster, Andreas and Willen, Paul, Insuring Consumption Using Income-Linked Assets (February 24, 2010). FRB of Boston Working Paper No. 10-1. Available at SSRN: https://ssrn.com/abstract=1566976 or http://dx.doi.org/10.2139/ssrn.1566976

Andreas Fuster

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Paul S. Willen (Contact Author)

Federal Reserve Bank of Boston - Research Department ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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