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

23 Pages Posted: 9 Aug 2012

See all articles by Reda Cherif

Reda Cherif

International Monetary Fund (IMF)

Fuad Hasanov

International Monetary Fund

Date Written: May 2012

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.

Keywords: Volatility, Risk, Precautionary Saving, Buffer-stock, Growth, Economic Growth, Economic Models, External Shocks, Savings

JEL Classification: E21, E22, D91, O40

Suggested Citation

Cherif, Reda and Hasanov, Fuad, The Volatility Trap: Precautionary Saving, Investment, and Aggregate Risk (May 2012). IMF Working Paper No. 12/134. Available at SSRN: https://ssrn.com/abstract=2127028

Reda Cherif (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Fuad Hasanov

International Monetary Fund ( email )

Washington, DC 20431
United States

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