Risk Sensitivity and Stationary Equilibrium in Incomplete Markets

Abstract

We study stationary equilibrium and comparative statics in an incomplete market economy with risk-sensitive preferences. We prove that a stationary equilibrium exists for every nonnegative degree of risk sensitivity. With independent income, greater risk sensitivity weakly raises aggregate saving at fixed prices and weakly lowers the smallest and the largest equilibrium interest rates. With stochastically monotone Markov income, these comparisons hold when the lower risk-sensitivity parameter is sufficiently small or the upper parameter sufficiently large. For pairs of intermediate values, however, greater risk sensitivity can lower saving, contrary to an existing result in the literature, and can raise the smallest and largest equilibrium rates. An exact decomposition identifies the forces driving these reversals.