Preferences for risk in dynamic models with adjustment costs

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Abstract

This paper characterizes the solution to a consumption/savings decision problem in which one of the consumption goods involves transaction costs. It then analyzes how such adjustment costs affect consumers' risk attitudes. Previous studies have suggested that transaction costs, by resulting in infrequent but lumpy adjustments, magnify consumers' risk aversion with respect to moderate-stake risk and, simultaneously, stimulate the demand for large-stake wealth lotteries. This paper argues that such predictions, while naturally arising in static models, may disappear or even reverse in a dynamic setting, in which consumers can choose when to make an adjustment. Namely, it shows that such an option can eliminate the demand for large-stake lotteries, and that the consumers choosing to delay the adjustment may be more tolerant to moderate-stake risks than in the absence of adjustment costs. The paper also illustrates that both predictions crucially depend on the relationship between the time discount rate in the utility function and the interest rate.

Original languageEnglish (US)
Pages (from-to)86-106
Number of pages21
JournalReview of Economic Dynamics
Volume17
Issue number1
DOIs
Publication statusPublished - Jan 2014

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Keywords

  • Adjustment costs
  • Borrowing constraints
  • Consumption commitments
  • Dynamic discrete choice
  • Equity premium puzzle
  • Housing
  • Lotteries
  • Patience
  • Risk aversion

ASJC Scopus subject areas

  • Economics and Econometrics

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