Lecture 2 - FM201 - LSE
Lecture 2 - FM201 - LSE
Uncertainty
Expected utility
1
Where β = 1+δ
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Consumption
Uncertainty
Expected utility
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.
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.
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Consumption
Uncertainty
Expected utility
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!
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Consumption
Uncertainty
Labor income uncertainty - complete markets
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:”
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Consumption
Uncertainty
Labor income uncertainty - complete markets
Euler Equations
Intertemporal optimization:
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!
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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.
a1 = (1 + r )(a0 + y0 − c0 )
a2 = (1 + r )(a1 + y1 − c1 ) = 0 ⇐⇒ c1 = a1 + y1
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Consumption
Uncertainty
Precautionary savings - incomplete markets
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.
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Consumption
Uncertainty
Precautionary savings - incomplete markets
Euler Equation
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.
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Consumption
Uncertainty
Log-Linear Euler Equation - derivation
If ln(x) is conditionally normally distributed with mean E [ln(x)] and variance Var [ln(x)]
1 γ
E0 (gc ) = (r − δ) + Var (gc )
γ 2
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Consumption
Uncertainty
Applications: 1) Precautionary Savings
One of the main mandates of central banks is to create stability (minimize uncertainty)
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Consumption
Uncertainty
Applications: 2) PIH - Random walk
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
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Consumption
Uncertainty
Recap and empirical findings
PIH - random walk main prediction: predictable changes in income should not explain
changes in consumption.
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Consumption
Uncertainty
Recap and empirical findings
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.
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Consumption
Uncertainty
Recap and empirical findings
Policy implications
LC: consumption is a function of total wealth (financial and human) and its
composition changes over the life cycle.
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