Incentive and Welfare Effects of an Idiosyncratic Interest Rate
32 Pages Posted: 29 Mar 2018 Last revised: 2 Mar 2019
Date Written: February 28, 2019
We provide a microeconomic analysis of the incentive and welfare effects of an idiosyncratic interest rate at the individual level. While most of the existing literature has focused on interest rate risk as an aggregate shock, we allow for correlation between interest rate risk and the agent's non-financial endowment. Using a simple consumption-saving model with two periods, time-separable utility, and two states of nature allows us to rewrite an idiosyncratic interest rate with the help of a transfer rate that measures the spread between the interest rate in the good and the bad state of nature. At the extensive margin, a critical level of the transfer rate separates savers from borrowers. At the intensive margin, we identify restrictions on the agent's preferences for a larger transfer rate to raise saving. Furthermore, we analyze the welfare effects of an idiosyncratic interest rate by characterizing the transfer rate that maximizes an individual's intertemporal expected utility. This reveals that the potential welfare benefits of an idiosyncratic interest rate are related to its insurance effects.
Keywords: correlation attitude, risk preferences, saving, idiosyncratic interest rate
JEL Classification: D14, D15, D60, D81, E21, E43
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