By Yulei Luo, Jun Nie and Eric Young
This paper develops a tractable continuous-time recursive utility (RU) version of the Huggett (1993) model to explore how the preference for robustness (RB) interacts with intertemporal substitution and risk aversion and then affects the interest rate, the dynamics of consumption and income, and the welfare costs of model uncertainty in general equilibrium. We show that RB reduces the equilibrium interest rate and the relative volatility of consumption growth to income growth when the income process is stationary, but our benchmark model cannot match the observed relative volatility. An extension to an RU-RB model with a risky asset is successful at matching this ratio. The model implies that the welfare costs of uncertainty are very large.
I was not aware of a continuous-time version of the Huggett model, and it looks like a pretty powerful tool. It may be useful in addressing questions that are too difficult for the discrete-time version, like in this paper.