Evaluating Risky Consumption Paths: the Role of Intertemporal Substitutability

39 Pages Posted: 27 Jun 2007

See all articles by Maurice Obstfeld

Maurice Obstfeld

University of California, Berkeley - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: January 1995

Abstract

In dynamic stochastic welfare comparisons, a failure clearly to distinguish between risk aversion and intertemporal substitutability can result in misleading assessments of the impact of risk aversion on the welfare costs of consumption-risk changes. The problem arises in any setting in which uncertainty is propagated over time, notably, but not exclusively, in economies with stochastic consumption trends. Regardless of the preference setup adopted, an increase in risk aversion amplifies the per-period costs of risks. The weights consumers use to cumulate the per-period costs of risks with persistent effects should, however, depend on intertemporal substitutability as well as on risk aversion. Under time-separable expected-utility preferences, an increase in the period utility function's curvature therefore alters the welfare effect of risk for reasons that in part are unrelated to risk aversion.

Suggested Citation

Obstfeld, Maurice, Evaluating Risky Consumption Paths: the Role of Intertemporal Substitutability (January 1995). NBER Working Paper No. t0120. Available at SSRN: https://ssrn.com/abstract=995456

Maurice Obstfeld (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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HOME PAGE: http://emlab.berkeley.edu/users/obstfeld/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

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