PRECAUTIONARY SAVING - AN EXPLANATION FOR EXCESS SENSITIVITY OF CONSUMPTION

The permanent income hypothesis under certainty equivalence yields a martingale consumption process. Empirically, this hypothesis is rejected because consumption is excessively sensitive to anticipated income. One approach to account for excess sensitivity is to relax cetainty equivalence by using utility functions that induce precautionary saving. This article analyzes a hyperbolic absolute risk-aversion utility function. Empirically, some reasonable parameterizations of this specification allow one to match the excess sensitivity associated with the data. These parameterizations also permit one to account for the excess smoothness problem. Excess sensitivity and excess smoothness, however, do not reflect the same phenomenon.