Bad News and Robust Comparative Statics for the Elasticity of Intertemporal Substitution

39 Pages Posted: 4 Jan 2015 Last revised: 8 Oct 2019

See all articles by Lawrence Schmidt

Lawrence Schmidt

MIT Sloan School of Management

Alexis Akira Toda

University of California, San Diego (UCSD) - Department of Economics

Date Written: October 2019

Abstract

We define the elasticity of intertemporal substitution (EIS) for general recursive preferences and identify sharp comparative statics from a general dynamic portfolio choice problem. In many cases, when preferences are homothetic, if EIS is smaller (larger) than 1, an investor will decrease (increase) current consumption in response to bad news about the future. Examples of bad news include (i) becoming more risk averse, (ii) less investment opportunities, (iii) riskier returns, or (iv) more uncertainty about the distribution of returns. Bad news effectively raises the price of future continuation utility, which produces the same qualitative changes in savings rates as lowering the interest rate. Similar results hold for the consumption response to changes in business investment opportunities in an extension to entrepreneurs making joint consumption, financial investment, and capital accumulation decisions. We also provide guidance on simple empirical tests for this condition on EIS based on our comparative statics results.

Keywords: elasticity of intertemporal substitution, optimal portfolio problem, recursive preferences

JEL Classification: D91, E21, G11

Suggested Citation

Schmidt, Lawrence and Toda, Alexis Akira, Bad News and Robust Comparative Statics for the Elasticity of Intertemporal Substitution (October 2019). Available at SSRN: https://ssrn.com/abstract=2544688 or http://dx.doi.org/10.2139/ssrn.2544688

Lawrence Schmidt

MIT Sloan School of Management ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

HOME PAGE: http://https://sites.google.com/site/lawrencedwschmidt/home

Alexis Akira Toda (Contact Author)

University of California, San Diego (UCSD) - Department of Economics ( email )

9500 Gilman Drive
Mail Code 0508
La Jolla, CA 92093-0508
United States

HOME PAGE: http://https://sites.google.com/site/aatoda111/

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