Optimal Consumption and Savings with Stochastic Income and Recursive Utility

55 Pages Posted: 10 Aug 2013

See all articles by Chong Wang

Chong Wang

Naval Postgraduate School - Graduate School of Business and Public Policy

Neng Wang

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Jinqiang Yang

Shanghai University of Finance and Economics

Date Written: August 2013

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.

Suggested Citation

Wang, Chong and Wang, Neng and Yang, Jinqiang, Optimal Consumption and Savings with Stochastic Income and Recursive Utility (August 2013). NBER Working Paper No. w19319. Available at SSRN: https://ssrn.com/abstract=2308287

Chong Wang (Contact Author)

Naval Postgraduate School - Graduate School of Business and Public Policy ( email )

555 Dyer Road
Monterey, CA 93943
United States

Neng Wang

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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