RWP 17-13, November 2017; updated April 2020
This paper studies how two types of uncertainty due to ignorance interact to affect households’ strategic decisions on their consumption, investment, and precautionary savings. Specifically, we construct a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth. After solving the model explicitly, we theoretically and quantitatively explore how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, as well as how they jointly affect strategic asset allocation, precautionary savings, and the equilibrium asset returns. Next, 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 explaining the data. Finally, we find that the welfare costs of ignorance can be very large.
JEL Classification: C61, D81, E21
Luo, Yulei, Jun Nie, Haijun Wang. 2020. “Ignorance, Pervasive Uncertainty, and Household Finance.” Federal Reserve Bank of Kansas City, working paper no. 17-13, April. Available at External Linkhttps://doi.org/10.18651/RWP2017-13