Bad News and Robust Comparative Statics for the Elasticity of Intertemporal Substitution
39 Pages Posted: 4 Jan 2015 Last revised: 8 Oct 2019
Date Written: October 2019
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: Suggested Citation