Lau, ChiLei Oscar (2008): Disentangling Intertemporal Substitution and Risk Aversion under the Expected Utility Theorem.

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Abstract
A disturbing feature of the conventional objective function for intertemporal decisions under uncertainty is that the agent's attitudes toward intertemporal substitution and risk aversion are entangled. This paper shows that, in contrast to common perception, the two attitudes can be completely disentangled under the expected utility theorem (EUT) by modeling each of them successively in two steps. The conventional form is nested as a special case where the functions describing the two attitudes are identical. The proposed framework requires only the standard axioms of the EUT, in addition to a regulatory assumption. It is flexible in accommodating different combinations of the two attitudes, indifferent to the timing of resolution of uncertainty, intuitive to interpret, and extendable to multiple goods.
The objective function under the proposed framework is time inconsistent according to Strotz's (1955) definition. I argue that Strotz's notion of time consistency is misguided. It is constructed based on a priori assumption that the agent should continuously forget history as time progresses. But this means the agent is either chronically amnesiac or selfcontradictory. To be truly consistent, the agent should have one and only one objective function, determined at birth, throughout his entire life. As history unfolds, the agent updates his information set, but not his objective function.
Item Type:  MPRA Paper 

Original Title:  Disentangling Intertemporal Substitution and Risk Aversion under the Expected Utility Theorem 
Language:  English 
Keywords:  Intertemporal substitution; Risk aversion; Expected utility theorem; Time consistency; Equity premium puzzle 
Subjects:  D  Microeconomics > D8  Information, Knowledge, and Uncertainty > D81  Criteria for DecisionMaking under Risk and Uncertainty G  Financial Economics > G1  General Financial Markets > G12  Asset Pricing; Trading volume; Bond Interest Rates D  Microeconomics > D9  Intertemporal Choice and Growth > D91  Intertemporal Consumer Choice; Life Cycle Models and Saving E  Macroeconomics and Monetary Economics > E2  Macroeconomics: Consumption, Saving, Production, Employment, and Investment > E21  Consumption; Saving; Wealth 
Item ID:  11482 
Depositing User:  ChiLei Oscar Lau 
Date Deposited:  10. Nov 2008 00:18 
Last Modified:  20. Feb 2013 20:34 
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URI:  http://mpra.ub.unimuenchen.de/id/eprint/11482 