Abstract
This paper analyzes a continuous time stochastic growth model with a Duffie and Epstein (Duffie, D., and L. Epstein. 1992. “Stochastic Differential Utility.” Econometrica 60: 353–394.) recursive utility. We find that optimal consumption decisions are determined in a non trivial way by factors such as changes in expectations about future prospects (sentiment), and a matrix of weights that expresses the sensitivity of the consumer to a global macroeconomic risk. The weighting matrix can also be thought of as a measure of multivariate prudence.The sentiment channel is governed by two forces working in opposite directions; one is related to the consumer’s aversion to long-run risk and the other is related to the consumer’s aversion to short-run risk. The greater is the aversion to long-run risk relative to the aversion to short-run risk, the higher is the magnitude of the sentiment effect. This suggests a linkage between the sentiment effect and temporal risk attitudes.
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