Robust Permanent Income in General Equilibrium

Abstract

This paper provides a tractable continuous-time constant-absolute-risk averse (CARA)-Gaussian framework to quantitatively explore how the preference for robustness (RB) affects the interest rate, the dynamics of consumption and income, and the welfare costs of model uncertainty in general equilibrium. We show that RB significantly reduces the equilibrium interest rate, and reduces (increases) the relative volatility of consumption growth to income growth when the income process is stationary (non-stationary). Furthermore, we find that the welfare costs of model uncertainty are nontrivial for plausibly estimated income processes and calibrated RB parameter values. Finally, we extend the benchmark model to consider the separation of risk aversion and intertemporal substitution, incomplete information about income, and regimeswitching in income growth. JEL Classification Numbers: C61, D81, E21.