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Lecture 2 - FM201 - LSE

The document discusses the incorporation of uncertainty into consumption analysis through the expected utility model, highlighting risks such as labor income and asset return uncertainty. It explains the concept of precautionary savings under incomplete markets, where households save to mitigate risks, and presents the implications of the Permanent Income Hypothesis and Life Cycle theory on consumption behavior. Additionally, it addresses empirical findings and policy implications related to consumption and uncertainty.

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0% found this document useful (0 votes)
20 views14 pages

Lecture 2 - FM201 - LSE

The document discusses the incorporation of uncertainty into consumption analysis through the expected utility model, highlighting risks such as labor income and asset return uncertainty. It explains the concept of precautionary savings under incomplete markets, where households save to mitigate risks, and presents the implications of the Permanent Income Hypothesis and Life Cycle theory on consumption behavior. Additionally, it addresses empirical findings and policy implications related to consumption and uncertainty.

Uploaded by

jacktian787878
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 14

Consumption

Uncertainty
Expected utility

Risks faced by households


Let us now introduce uncertainty into our analysis:

Labor income uncertainty

Asset return uncertainty

How do we incorporate uncertainty? The mainstream approach is to consider the expected


utility model. " #
T
X t
Max E0 β u(ct )
{ct }T
t=0 t=0

s.t the Intertemporal Budget Constraint


" T # " T
#
X ct X yt
E0 = E0 a0 +
t=0
(1 + r )t t=0
(1 + r )t

1
Where β = 1+δ
1 / 14
Consumption
Uncertainty
Expected utility

Expected Utility function

The lifetime utility function is assumed to be separable over time (as we have seen before)
and across states (discrete example):

T X
X S
E0 [U] = β t πs u(cts )
t=0 s=1

The instantaneous utility function u(cts ) is now defined over consumption across
different possible states. πs is the probability of each state.

We continue to assume that it is concave u 0 > 0, u 00 < 0.

Now the degree of concavity will define not only the willingness to substitute
consumption over time but also the willingness to substitute consumption across states
of the world, i.e. how risk averse consumers are.

2 / 14
Consumption
Uncertainty
Expected utility

Utility function

Luckily, we carry on using our well known power utility function.

c 1−γ
u(c) =
1−γ

In this case, the most common measure of risk aversion (the coefficient of relative risk
aversion) is constant and equal to γ!

3 / 14
Consumption
Uncertainty
Labor income uncertainty - complete markets

Consumption optimization: Two periods and two states of the world.

Assume that in t = 1 there are two possible states of the world s = g (good) or s = b
(bad) with probabilities π and (1 − π), respectively.
Complete markets: means that there is insurance available (in all states of the world) so
that households can fully hedge all their risks.
The household solves the following optimization problem:
h i
g b
Max
g
E0 [U] = u(c 0 ) + β πu(c1 ) + (1 − π)u(c 1 )
c0 ,c1 ,c1b

1 h i 1 h i
c0 + πc1g + (1 − π)c1b = a0 + y0 + πy1g + (1 − π)y1b
(1 + r ) (1 + r )
Build the Lagrangian function and from the FOC we get two “Euler Equations:”

4 / 14
Consumption
Uncertainty
Labor income uncertainty - complete markets

Euler Equations

Intertemporal optimization:

u 0 (c0 ) = (1 + r )βE0 u 0 (c1 )


 

Optimization across states


u 0 (c1g ) = u 0 (c1b ) ⇐⇒ c1g = c1b

Result: with complete markets households will fully insure their labor income risks,
transferring income from the good state to the bad state. They are able to smooth
consumption across states.
However, most of the times this is not possible, markets are incomplete, so individuals have
to self insure: i.e. save for a rainy day!

5 / 14
Consumption
Uncertainty
Precautionary savings - incomplete markets

Precautionary savings
Under incomplete markets, labor income uncertainty induces households to save.
This is known as the Precautionary Savings Motive.
Let us look at the two period optimization problem. In this case we assume that (c1 ) is a
continuous random variable.

Max E0 [U] = u(c0 ) + βE0 [u(c1 )]


c0 ,c1

s.t. Transition equation (dynamic BC)

a1 = (1 + r )(a0 + y0 − c0 )

And the usual terminal value constraints imply that:

a2 = (1 + r )(a1 + y1 − c1 ) = 0 ⇐⇒ c1 = a1 + y1
6 / 14
Consumption
Uncertainty
Precautionary savings - incomplete markets

Technical note on multi-period models

The optimization problem for T > 2 is formulated in a similar way. However, since under
incomplete markets the problem has to be solved for every possible realization of future
income, for most utility functions, the optimization problem does not have a closed form
(analytical) solution and therefore it is solved numerically. These methods will not be
covered in this course.

7 / 14
Consumption
Uncertainty
Precautionary savings - incomplete markets

Euler Equation

The Euler Equation for the two period problem is

u 0 (c0 ) = (1 + r )βE0 u 0 (c1 )


 

Under the power utility function and assuming that consumption growth is log-normally
distributed this approximates to:

1 γ
E (gc ) = (r − δ) + Var (gc )
γ 2
This is an important result since it rationalizes the effect of uninsurable labor income risk
on current consumption. Higher risk increases expected consumption growth, i.e., decreases
current consumption and increases savings.

8 / 14
Consumption
Uncertainty
Log-Linear Euler Equation - derivation

u 0 (c0 ) = (1 + r )βE0 u 0 (c1 )


 

Under the power utility u 0 = c −γ


" −γ #
c1
1 = (1 + r )βE0
c0

Take ln on both sides


" −γ #!
c1
ln(1) = ln(1 + r ) + ln(β) + ln E0
c0

If ln(x) is conditionally normally distributed with mean E [ln(x)] and variance Var [ln(x)]

lnE (x) = E [ln(x)] + Var [ln(x)]/2


 −γ
c1
Set x = c0
and approximate ln(c1 /c0 ) = ln(1 + gc ) ≈ gc

1 γ
E0 (gc ) = (r − δ) + Var (gc )
γ 2
9 / 14
Consumption
Uncertainty
Applications: 1) Precautionary Savings

1) Precautionary savings: Application

Why do politicians love the sound of a “Strong and Stable” government?

One of the main mandates of central banks is to create stability (minimize uncertainty)

Financial markets always on the look for consumer confidence

10 / 14
Consumption
Uncertainty
Applications: 2) PIH - Random walk

2) Permanent Income Hypothesis: Application


If we assume that the utility function is quadratic: the marginal utility is linear and there is
no precautionary savings motive. Households choose consumption “as if” there is no
uncertainty.
Et (ct+1 ) = ct ⇐⇒ ct+1 = ct + t+1

The prediction of this version of the PIH is that consumption should only respond to
unanticipated shocks to labor income, i.e., should only respond to the news about future
labor income.
Rational Expectations: consumers incorporate all available information in current
consumption (expectations about future income which determine their permanent income)
and will only change consumption when “unexpected” news about future income arrive.

Et (t+1 ) = 0

11 / 14
Consumption
Uncertainty
Recap and empirical findings

Reconciling theory with data - PIH

PIH - random walk main prediction: predictable changes in income should not explain
changes in consumption.

Usually rejected both using aggregate and micro data.

Precautionary savings and borrowing constraint offer potential explanations.

12 / 14
Consumption
Uncertainty
Recap and empirical findings

Reconciling theory with data - LC

Survey data also indicates that many households do not smooth consumption over the
Life Cycle as predicted.

Consumption tracks income early in life - could be due to borrowing constraints and
precautionary savings.

Wealth decumulation during retirement is lower than predicted, can partly be


rationalized by uncertainty (longevity and medical expenditures) and bequest motives.

13 / 14
Consumption
Uncertainty
Recap and empirical findings

Policy implications

Precautionary savings: boost consumption by reducing uncertainty (or providing


insurance).

PIH - Random walk: only unanticipated “stimulus” packages affect consumption.

LC: consumption is a function of total wealth (financial and human) and its
composition changes over the life cycle.

14 / 14

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