Optimal Consumption and Savings Decisions with Disastrous Income Risk: Revisiting Rietz's Rare Disaster Risk Hypothesis

Abstract

In this paper, we develop an analytically tractable dynamic model of optimal consumption and savings decisions with disastrous income risk. We first empirically explore the relations among consumption changes, aggregate income, disaster shock severity, and fiscal measures in 55 countries during the Covid-19 period. We then by empirical motivation investigate an important role of insurance with a focus on the recovery of income in a disaster. We highlight how extent of the disastrous income risk to which the agent is exposed and her income recovery post disaster jointly affect the agent's optimal decisions. Overall, availability of insurance can be particularly important for both the poor and the wealthy in the sense that they could even consume more, save less, and invest more post disaster as long as their future income is (partly) recovered.

Keywords: Optimal Consumption, Optimal Savings, Disastrous Income Risk, Insurance

JEL Classification: D15, D58, G11, G12