Fed in Print

Abstract

This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Furthermore, we use data to test our model’s predictions on the relationship between ignorance and asset allocation and quantitatively show that the interaction between the two types of uncertainty is the key to explain the data. Finally, we find that the welfare costs of ignorance can be very large.

JEL Classification:

C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

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