NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability

Maurice Obstfeld

NBER Technical Working Paper No. 120
Issued in January 1995
NBER Program(s):   EFG

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.

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Document Object Identifier (DOI): 10.3386/t0120

Published: European Economic Review, August 1994

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