Savings with Income Uncertainty and Habit Formation

Jiang Jiaxin

Abstract

Income uncertainty and habit formation both affect savings rates. In this paper, we build a simplified overlapping-generations model to study the interaction of these two factors. We start with a microeconomic problem of an individual agent’s consumption and saving decisions. Using a sequential optimization (backward induction) procedure, we determine the three-period-lived agent’s optimal savings. Then we examine the macroeconomic variable of our interest – the aggregate savings rate. After deriving analytical solutions as much as possible, we try to match the model to the data of East Asian countries, in particular South Korea. We show that income uncertainty and habit formation both have a positive effect on the savings rate. However, they dampen each other’s effect on the savings rate to a certain extent. Moreover, we examine how the magnitude of their effects varies under different circumstances, including more optimistic expectation about future income, different economic and population growth rates, faster salary growth etc.