Optimal Consumption and Savings with Stochastic Income

Authors: Chong Wang, Neng Wang and Jinqiang Yang
Publication: NBER Working Paper No. 19319, August 2013

Abstract: We develop an analytically tractable consumption-savings model for a liquidity-constrained agent who faces both permanent and transitory income shocks. We find that risk aversion and intertemporal substitution have very different effects on both consumption and the steady-state savings target. Moderate changes in risk aversion have large effects on consumption and buffer-stock savings. With permanent shocks, it takes many years to reach the steady-state savings target. We also find that large discrete income shocks (jumps) occurring at low frequencies can be very costly. Unlike conventional wisdom, transitory shocks can generate very large precautionary savings demand, especially for low transitory income states.

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