Risk-sensitive preferences and age-dependent risk aversion

By Phitawat Poonpolkul


People in different age groups have shown to differ in their degrees of risk aversion. This study investigates the macroeconomic implications of population aging when households are assumed to be increasingly risk-averse in future utility when they age. The model incorporates risk-sensitive preferences used in Hansen & Sargent (1995), which is the only recursive preferences that can separate risk aversion and intertemporal elasticity of substitution while being monotonic, into a 16-generation discrete-time OLG model with undiversifiable income risk. Compared to a time-additive counterpart, risk-sensitive preferences capture precautionary saving motive that exacerbates adverse responses of aggregate macroeconomic variables under a population aging scenario through demographic re-weighting and life-cycle redistribution channels. Varying risk aversion also allows households to internalize future uncertainties when evaluating their welfare impacts of demographic change, resulting in non-monotonic welfare dynamics with higher welfare loss under a high-risk environment and vice versa. Risk-sensitive preferences with age-dependent risk aversion can play an important role in optimal policy settings by introducing uncertainties into the welfare impact analysis, while taking into account more realistic risk-taking behavior of different age cohorts.

Making this kind of differentiation does not matter in most setups, but when we are taking precautionary savings over the life cycle, it definitively does. Add a major financial-market based recession in there, and you could get some major policy conclusions.

One Response to Risk-sensitive preferences and age-dependent risk aversion

  1. Phitawat Poonpolkul says:

    Given that risk aversion is one of the key elements that affect household decisions and macroeconomic aggregates, assumption of a constant risk aversion in an OLG model (which contradict many findings that degrees of risk aversion vary with age) may not be realistic and may overlook precautionary savings that is crucial in a life-cycle model. I am currently extending this study by improving estimations of age-dependent risk aversion as well as improving this framework to evaluate optimal fiscal policy. Since the model allows different age cohorts to internalize future uncertainties when evaluating welfare impacts, the policy implication may substantially differ from previous studies.

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