Instability of Wealth Effect on Consumption and Investment Under Regime Switches

22 Pages Posted: 26 Jan 2018 Last revised: 8 Jun 2018

See all articles by Toshio Kimura

Toshio Kimura

Sumitomo Mitsui Trust Bank, Limited

Naoki Makimoto

University of Tsukuba - Graduate School of Business Sciences

Date Written: May 30, 2018

Abstract

The instability of wealth effect on consumption over the business cycles is widely recognized in recent empirical studies. We develop a consumption and investment problem for an investor with direct preference for wealth where the drift and volatility of asset return switches between two regimes. Furthermore, the model is extended to allow the investor's borrowing rate to be higher than her risk-free rate. An utility-maximizing policy is derived explicitly such that optimal consumption-wealth ratio depends not only on both current and future regimes, but also on the transition across different regimes. Numerical simulation demonstrates that low frequent changes in regimes produce instability of consumption-wealth ratio, while high frequent regime-shifts produce stable consumption-wealth ratio. These features are enhanced by investor's wealth accumulation motive and tighter credit spread between borrowing rate and risk-free rate, both of which can be applied to explain the instability of consumption-wealth ratio observed in the U.S.

JEL Classification: D91; E21; G11

Suggested Citation

Kimura, Toshio and Makimoto, Naoki, Instability of Wealth Effect on Consumption and Investment Under Regime Switches (May 30, 2018). Asian Finance Association (AsianFA) 2018 Conference. Available at SSRN: https://ssrn.com/abstract=3109655 or http://dx.doi.org/10.2139/ssrn.3109655

Toshio Kimura (Contact Author)

Sumitomo Mitsui Trust Bank, Limited ( email )

Japan

Naoki Makimoto

University of Tsukuba - Graduate School of Business Sciences ( email )

3-29-1 Otsuka
Bunyo, Tokyo, 112-0012
Japan

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