Buffer stocks and precautionary savings with loss aversion

This paper reexamines buffer stocks and precautionary savings in the presence of loss aversion. We assume that agents are disappointment averse, as in Gul [Econometrica, 59 (1991) 667-686]. We show that the concavity of the marginal utility continues to determine precautionary saving, but its effect is of a second order magnitude (proportional to the square of the coefficient of variation) compared to the first order effect (proportional to the coefficient of variation) induced by loss aversion. We show that a stabilization fund that is rather small when agents are maximizing the conventional expected utility, turns out to be rather large with loss aversion. (C) 1998 Elsevier Science Ltd. All rights reserved.