Incentive and Welfare Effects of an Idiosyncratic Interest Rate

32 Pages Posted: 29 Mar 2018 Last revised: 2 Mar 2019

See all articles by Christophe Courbage

Christophe Courbage

Haute Ecole de Gestion de Genève - University of Applied Sciences Western Switzerland (HES-SO)

Richard Peter

University of Iowa

Béatrice Rey

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE)

Date Written: February 28, 2019

Abstract

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

Suggested Citation

Courbage, Christophe and Peter, Richard and Rey, Béatrice, Incentive and Welfare Effects of an Idiosyncratic Interest Rate (February 28, 2019). Available at SSRN: https://ssrn.com/abstract=3152399 or http://dx.doi.org/10.2139/ssrn.3152399

Christophe Courbage

Haute Ecole de Gestion de Genève - University of Applied Sciences Western Switzerland (HES-SO) ( email )

Geneva
Switzerland

Richard Peter (Contact Author)

University of Iowa ( email )

341 Schaeffer Hall
Iowa City, IA 52242-1097
United States

Béatrice Rey

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE) ( email )

93, chemin des Mouilles
Ecully, 69130
France

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