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The effects of uncertainty on optimal consumption. (English) Zbl 0956.91047

Summary: When marginal utility is convex and there is pure labour income uncertainty, certain results are well-known. Asset return uncertainty is often assumed to have qualitatively similar effects [see e.g. Skinner, J. Monetary Econ. 22, 237-255 (1988)]. We show that this assumption is not correct. Asset return uncertainty gives rise to an additional term in the Euler equation, which by introducing a role for current cash-in-hand, may work in the opposite direction to the precautionary motive, leading to ambiguity in the slope of the expected consumption time profile. We present a linearised version of the Euler equation, and an associated closed-form solution, in order to provide intuition for these results. Numerical analysis indicates that the approximation is reasonable for empirically plausible estimates of the variances of the underlying disturbances.

MSC:

91B40 Labor market, contracts (MSC2010)
91B42 Consumer behavior, demand theory
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