Interest rate risk, labor supply and unemployment

When the rate of return on an individual's savings is risky, the access to a labor market to work for a riskless wage provides a means of hedging this capital income risk by working more. In a non-expected utility maximizing framework using Selden's OCE preference we investigate the effects of a change in the rate of return risk on such precautionary labor supply decision. It is shown that an increase in the rate of return risk leads to an increase (a decrease) in the optimal labor supply only when the elasticity of intertemporal substitution for consumption falls short of (exceeds) unity. An empirical analysis, using a GARCH model to estimate the interest rate risk, reveals that in the US, unemployment rate has responded positively to an increase in time-varying real interest rate risk. (C) 2001 Elsevier Science B.V. All rights reserved.