Determinants of Precautionary Savings: Elasticity of Intertemporal Substitution vs. Risk Aversion

The purpose of this paper is to understand the effects of the elasticity of intertemporal substitution (EIS), the percentage change in intertemporal consumption in response to a given percentage change in the intertemporal price, and risk aversion on savings separately and determine which coefficient is more important factor for precautionary savings.Our model is the standard problem of a representative agent who lives for many periods and chooses optimal current consumption and next period’s bond holding in order to maximize the utility function. The source of uncertainty considered is in exogenous future income and there exist no markets in which agents can insure against this uncertainty.It is observed that EIS is a more important factor for precautionary savings than risk aversion because saving is more sensitive to changes in EIS than changes in risk aversion.