Ignorance, Pervasive Uncertainty, and Household Finance
43 Pages Posted: 7 Sep 2017 Last revised: 30 Sep 2019
Date Written: September 4, 2017
This paper studies how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules, precautionary savings, and welfare in general equilibrium. We incorporate these two types of uncertainties into a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth and derive analytical solutions and testable implications. We show that the interaction between the two types of uncertainty plays a key role in determining the demand for precautionary savings and risky assets. We derive formulas to evaluate both marginal and total welfare costs of ignorance-induced uncertainty and show they are significant for plausible parameter values.
Keywords: Ignorance, Unknown Income Growth, Induced Uncertainty, Strategic Asset Allocation
JEL Classification: C61, D81, E21
Suggested Citation: Suggested Citation