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Precautionary saving and partially observed income

Authors
Journal
Journal of Monetary Economics
0304-3932
Publisher
Elsevier
Publication Date
Volume
51
Issue
8
Identifiers
DOI: 10.1016/j.jmoneco.2004.06.001
Keywords
  • Precautionary Saving
  • Separation Principle
  • Incomplete Information
  • Kalman Filter

Abstract

Abstract I propose an intertemporal precautionary saving model in which the agent's labor income is subject to (possibly correlated) shocks with different degrees of persistence and volatility. However, he only observes his total income, not individual components. I show that partial observability of individual components of income gives rise to additional precautionary saving due to estimation risk, the error associated with estimating individual components of income. This additional precautionary saving is higher, when estimation risk is greater. Compared with a precautionary agent who is otherwise identical, but ignores estimation risk, the rational agent consumes less at the beginning of his life, but consumes more later, because of larger wealth accumulated from savings for estimation risk. The utility cost of ignoring estimation risk is also quantified in closed form.

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