Optimal Consumption and Savings with Stochastic Income and Recursive Utility
39 Pages Posted: 24 Jan 2015
Date Written: January 20, 2015
We develop a tractable continuous-time consumption-savings model for a liquidity-constrained agent who faces both permanent and transitory income shocks under incomplete markets. We derive an explicitly-solved consumption function and show that the marginal (certainty equivalent) value of liquidity measures the effects of financial frictions on welfare. We further analytically characterize steady-state target savings and demonstrate that risk aversion and inter-temporal substitution have very different effects on savings and the dispersions of wealth and consumption.
Keywords: buffer stock; precautionary savings; incomplete markets; borrowing constraints; permanent income; non-expected utility
JEL Classification: G11, G31, E2
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