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Asian Review of Financial Research, Vol., No..
pp.691~780
pp.691~780
A Generalization of Friedman's Permanent Income Hypothesis with a Large, Negative Income Shock
Steven Kou Questrom School of Business, Boston University
Seyoung Park Nottingham University Business School, University of Nottingham
We generalize the Permanent Income Hypothesis (PIH) of Friedman (1957) with a large, negative income shock (LNIS). We quantify the required amount of pre- cautionary savings for consumption smoothing. We nd that with the LNIS, the precautionary savings could increase as wealth increases, consistent with the US data. We also provide a general equilibrium analysis with a focus on interest rate. The agent's demand for precautionary savings is suciently strong making her save at a high rate and thus lowering the equilibrium interest rate signicantly, which is particularly relevant to today's low-interest-rate environment. Finally, the LNIS signicantly improves our equilibrium model's ability to match the equity premium and risk-free rate of the century-long sample (1891-1994).
Steven Kou
Seyoung Park
We generalize the Permanent Income Hypothesis (PIH) of Friedman (1957) with a large, negative income shock (LNIS). We quantify the required amount of pre- cautionary savings for consumption smoothing. We nd that with the LNIS, the precautionary savings could increase as wealth increases, consistent with the US data. We also provide a general equilibrium analysis with a focus on interest rate. The agent's demand for precautionary savings is suciently strong making her save at a high rate and thus lowering the equilibrium interest rate signicantly, which is particularly relevant to today's low-interest-rate environment. Finally, the LNIS signicantly improves our equilibrium model's ability to match the equity premium and risk-free rate of the century-long sample (1891-1994).
Income Shock,Incomplete Market,Consumption Smoothing,Precautionary Savings,General Equilibrium