NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Consumption and Savings with Stochastic Income and Recursive Utility

Chong Wang, Neng Wang, Jinqiang Yang

NBER Working Paper No. 19319
Issued in August 2013, Revised in August 2016
NBER Program(s):EFG

We develop a tractable incomplete-markets model with an earnings process Y subject to permanent shocks and borrowing constraints. Financial frictions cause the marginal (certainty equivalent) value of wealth W to be greater than unity and decrease with liquidity w = W/Y . Additionally, financial frictions cause consumption to decrease with this endogenously determined marginal value of liquidity. Risk aversion and the elasticity of inter-temporal substitution play very different roles on consumption and the dispersion of w. Permanent earnings shocks, especially large discrete stochastic jumps, make consumption smoothing quantitatively difficult to achieve. Borrowing constraints and permanent discrete jump shocks can generate empirically plausible values for marginal propensities to consume in the range of 0.2 to 0.6.

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Document Object Identifier (DOI): 10.3386/w19319

Published: Journal of Economic Theory Volume 165, September 2016, Pages 292–331

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