Consumption and the timing of income risk

When formulating a plan for savings, does the timing of income risks matter? Should one be concerned with whether uncertainty in income is in the near term, or the distant future? Of course, and the impact of the timing of income risk is the subject of this article. Using a three-period framework, we provide approximate solutions for optimal consumption choices for preferences that display constant relative risk aversion and derive the relationship between innovations to income and innovations to consumption growth. These results are contrasted with those for quadratic preferences and preferences that display constant absolute risk aversion. We analyze consumption-saving plans for several different situations of near term and distant future income risk, and different kinds of preferences. We conclude with a demonstration of the high degree of accuracy of our consumption approximations by comparing them to exact values computed by stochastic simulation. (C) 1999 Elsevier Science B.V. All rights reserved.