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Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion

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  • Joshua Aizenman
Abstract
Developing countries use various risk reduction schemes, ranging from active management of buffer stocks and international reserves to commodity stabilization funds. The purpose of this paper is to reexamine the design of these schemes in a generalized expected utility maximization model where agents are disappointment averse. We derive first the generalized risk premium, showing that disappointment aversion increases the conventional risk premium by a term proportional to the standard deviation times the degree of disappointment aversion. Next, we show that disappointment aversion modifies the characteristics of precautionary saving. The concavity of the marginal utility continues to determine precautionary saving, but its effect is of a second order magnitude (proportional to the variance) compared to the first order effect (proportional to the standard deviation) induced by disappointment aversion. Hence, higher volatility increases the precautionary saving of a disappointment averse agent. This result applies even if the income process approaches a random walk. Finally, we reexamine the optimal size of buffer stocks, showing that disappointment aversion increases its size by a first order magnitude. A buffer stock that is rather small when agents are maximizing the conventional expected utility is rather large when agents are disappointment averse.

Suggested Citation

  • Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:5361
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    References listed on IDEAS

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    Cited by:

    1. Aizenman, Joshua & Marion, Nancy, 2003. "The high demand for international reserves in the Far East: What is going on?," Journal of the Japanese and International Economies, Elsevier, vol. 17(3), pages 370-400, September.
    2. Joshua Aizenman, 1999. "International Portfolio Diversification with Generalized Expected Utility Preferences," Canadian Journal of Economics, Canadian Economics Association, vol. 32(4), pages 995-1008, August.
    3. Hideaki Tamura & Yoichi Matsubayashi, 2014. "A New Solution to the Equity Premium Puzzle and the Risk-Free Rate Puzzle: Theory and Evidence," Discussion Papers 1422, Graduate School of Economics, Kobe University.

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    • F1 - International Economics - - Trade

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