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Robustness, Low Risk-Free Rates, and Consumption Volatility in General Equilibrium

Luo, Yulei and Nie, Jun and Young, Eric (2017): Robustness, Low Risk-Free Rates, and Consumption Volatility in General Equilibrium.

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Abstract

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.

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