Wealth in the Utility Function and Consumption Inequality
Abstract: Wealth in the utility function (WIU) has been increasingly used in macroeconomic models and this specification can be justified by a few theories such as Max Weber’s (1904-05, German; 1958) theory on “spirit of capitalism.” We incorporate the WIU into a general equilibrium consumption-portfolio choice model to study the implications of the WIU for consumption inequality, equilibrium interest rate, and equity premium—an unexplored area in the literature. Our general equilibrium framework features recursive exponential utility, uninsurable labor risks, and multiple assets and can deliver closed-form solutions to help disentangle the effects of the WIU in driving the key results. We show a stronger preference for wealth lowers the risk-free rate but increases the consumption inequality and equity premium in the equilibrium. We show these properties improve the model’s performance in explaining the data. We also compare the WIU with a closely related hypothesis, habit formation, and find that they have opposite effects on equilibrium asset returns and consumption inequality.
File format is application/pdf
Description: Full text
Provider: Federal Reserve Bank of Kansas City
Part of Series: Research Working Paper
Publication Date: 2021-12-22
Number: RWP 21-17