Consumption: Beyond Certainty Equivalence
NBER Working Paper No. 2496 (Also Reprint No. r1105)
This paper discusses the recent research on the consumption function that has attempted to relax the assumption of certainty equivalence. While there remain many open questions, both theoretical and empirical, it is clear that the assumption of certainty equivalence can be misleading. Under more plausible specifications of preferences toward risk, uncertainty lowers the level of consumption, increases the expected rate of growth of consumption, and increases the response of consumption to news about income. Moreover, changes in the amount of uncertainty are a potentially important source of fluctuations in consumption.
Published: The American Economic Review, Vol. 78, No. 2, pp. 173-177, (May 1988).