Optimal Risk Sharing with Time Inconsistency and Long-Run Risk
67 Pages Posted: 5 Dec 2019
Date Written: November 16, 2019
I examine the role of time inconsistency, modeled by hyperbolic discounting, for the dynamics of asset prices and the wealth distribution between agents. Naive time-inconsistent investors with recursive preferences overconsume and have a lower effective elasticity of intertemporal substitution (EIS) than otherwise similar investors who are time-consistent. In both survival and overlapping-generations economies with i.i.d. consumption growth, I show that the suboptimal consumption and saving decisions of the naive time-inconsistent investors endogenously generate long-run risks in the consumption dynamics of the time-consistent agents. As a result, the presence of naive shortsighted investors increases the risk-free rate, volatility, and risk premium in the economy.
Keywords: Time inconsistency, hyperbolic discounting, long-run risk, risk sharing
JEL Classification: D53, E21, G10, G41
Suggested Citation: Suggested Citation