Risk Aversion and the Labor Margin

in Dynamic Equilibrium Models
Eric T. Swanson
Federal Reserve Bank of San Francisco
eric.swanson
@
sf.frb.org
http://www.ericswanson.us
Abstract
The household’s labor margin has a substantial effect on risk aversion, and
hence asset prices, in dynamic equilibrium models even when utility is addi-
tively separable between consumption and labor. This paper derives simple,
closed-form expressions for risk aversion that take into account the house-
hold’s labor margin. Ignoring this margin can wildly overstate the house-
hold’s true aversion to risk. Risk premia on assets priced with the stochastic
discount factor increase essentially linearly with risk aversion, so measuring
risk aversion correctly is crucial for asset pricing in the model. Closed-form
expressions for risk aversion in models with generalized recursive preferences
and internal and external habits are also derived.
JEL Classification: E44, D81
Version 1.7
April 30, 2010
I thank Ivan Jaccard, Martin Schneider, Harald Uhlig, Elmar Mertens, Marcelo Ferman,
Jonas Fisher, Edward Nelson, Glenn Rudebusch, John Williams, and seminar participants
at the Federal Reserve Bank of San Francisco and Universit`a Bocconi for helpful dis-
cussions, comments, and suggestions. The views expressed in this paper, and all errors
and omissions, should be regarded as those solely of the author, and are not necessarily
those of the individuals listed above, the management of the Federal Reserve Bank of San
Francisco, or any other individual in the Federal Reserve System.
1
1. Introduction
In a static, one-period model with household utility u(·) defined over a single consumption
good, Arrow (1964) and Pratt (1965) defined the coefficients of absolute and relative risk
aversion, −u

(c)/u

(c) and −c u

(c)/u

(c). Difficulties immediately arise, however, when
one attempts to generalize these concepts to the case of many periods or many goods (e.g.,
Kihlstrom and Mirman, 1974). These difficulties are particularly pronounced in a dynamic
equilibrium model with labor, in which there is a double infinity of goods to consider—
consumption and labor in every future period and state of nature—all of which may vary in
response to a typical shock to household income or wealth.
The present paper shows how to compute risk aversion in dynamic equilibrium models
in general. First, we verify that risk aversion depends on the partial derivatives of the
household’s value function V with respect to wealth a—that is, the coefficients of absolute
and relative risk aversion are essentially −V
aa
/V
a
and −aV
aa
/V
a
, respectively. Even though
closed-form solutions for the value function do not exist in general, we nevertheless can derive
simple, closed-form expressions for risk aversion because derivatives of the value function are
much easier to compute than the value function itself. For example, in many DSGE models
the derivative of the value function with respect to wealth equals the current-period marginal
utility of consumption (Benveniste and Scheinkman, 1979).
The main result of the paper is that the household’s labor margin has substantial
effects on risk aversion, and hence asset prices. Even when labor and consumption are ad-
ditively separable in utility, they remain connected by the household’s budget constraint: in
particular, the household can absorb income shocks either through changes in consumption,
changes in hours worked, or some combination of the two. This ability to absorb shocks
along either or both margins greatly alters the household’s attitudes toward risk. For exam-
ple, if the household’s utility kernel is given by u(c
t
, l
t
) = c
1−γ
t
/(1 − γ) − χl
t
, the quantity
−c u
11
/u
1
= γ is often referred to as the household’s coefficient of relative risk aversion, but
in fact the household is risk neutral with respect to gambles over income or wealth—the
proper measure of risk aversion for asset pricing, as we show in Section 2. Intuitively, the
household is indifferent at the margin between using labor or consumption to absorb a shock
to income or wealth, and the household in this example is clearly risk neutral with respect to
gambles over hours. More generally, when u(c
t
, l
t
) = c
1−γ
t
/(1−γ)−χ
0
l
1+χ
t
/(1+χ), risk aver-
2
sion equals (γ
−1

−1
)
−1
, a combination of the parameters on the household’s consumption
and labor margins, reflecting that the household absorbs shocks using both margins.
1
While modeling risk neutrality is not a main goal of the present paper, risk neutrality
nevertheless can be a desirable feature for some applications, such as labor market search or
financial frictions, since it allows for closed-form solutions to key features of the model.
2
A
contribution of the present paper is to show ways to model risk neutrality that do not require
utility to be linear in consumption, which has undesirable implications for interest rates and
consumption growth. Instead, any utility kernel with zero discriminant can be used.
A final result of the paper is that risk premia computed using the Lucas-Breeden
stochastic discounting framework are essentially linear in risk aversion. That is, measuring
risk aversion correctly—taking into account the household’s labor margin—is necessary for
understanding asset prices in the model. Since much recent research has focused on bringing
dynamic stochastic general equilibrium (DSGE) models into closer agreement with asset
prices,
3
it is surprising that so little attention has been paid to measuring risk aversion
correctly in these models. The present paper aims to fill that void.
There are a few previous studies that extend the Arrow-Pratt definition beyond the
one-good, one-period case. In a static, multiple-good setting, Stiglitz (1969) measures risk
aversion using the household’s indirect utility function rather than utility itself, essentially
a special case of Proposition 1 of the present paper. Constantinides (1990) measures risk
aversion in a dynamic, consumption-only (endowment) economy using the household’s value
function, another special case of Proposition 1. Boldrin, Christiano, and Fisher (1997) apply
Constantinides’ definition to some very simple endowment economy models for which they
can compute closed-form expressions for the value function, and hence risk aversion. The
present paper builds on these studies by deriving closed-form solutions for risk aversion in
dynamic equilibrium models in general, demonstrating the importance of the labor margin,
and showing the tight link between risk aversion and asset prices in these models.
1
Note that the intertemporal elasticity of substitution in this example is still 1/γ, so a corollary of this
result is that risk aversion and the intertemporal elasticity of substitution are nonreciprocal when labor
supply can vary.
2
See, e.g., Mortensen and Pissarides (1994), and Bernanke, Gertler, and Gilchrist (1999).
3
See, e.g., Boldrin, Christiano, and Fisher (2001), Tallarini (2000), Rudebusch and Swanson (2008, 2009),
Van Binsbergen, Fernandez-Villaverde, Koijen, and Rubio-Ramirez (2008), and Backus, Routledge, and Zin
(2009).
3
The remainder of the paper proceeds as follows. Section 2 presents the main ideas of
the paper, deriving Arrow-Pratt risk aversion in dynamic equilibrium models for the time-
separable expected utility case and demonstrating the importance of risk aversion for asset
pricing. Section 3 extends the analysis to the case of generalized recursive preferences (Ep-
stein and Zin, 1989), which have been the focus of much recent research at the boundary
between macroeconomics and finance. Section 4 extends the analysis to the case of internal
and external habits, two of the most common intertemporal nonseperabilities in preferences
in both the macroeconomics and finance literatures. Section 5 discusses some general im-
plications and concludes. An Appendix provides details of derivations and proofs that are
outlined in the main text.
2. Time-Separable Expected Utility Preferences
To highlight the intuition and methods of the paper, we consider first the case where the
household has additively time-separable expected utility preferences.
2.1 The Household’s Optimization Problem and Value Function
Time is discrete and continues forever. At each time t, the household seeks to maximize the
expected present discounted value of utility flows:
E
t

¸
τ=t
β
τ−t
u(c
τ
, l
τ
), (1)
subject to the sequence of asset accumulation equations:
a
τ+1
= (1 + r
τ
)a
τ
+ w
τ
l
τ
+ d
τ
−c
τ
, τ = t, t + 1, . . . (2)
and transversality condition:
lim
T→∞
T
¸
τ=t
(1 + r
τ+1
)
−1
a
T+1
≥ 0, (3)
where E
t
denotes the mathematical expectation conditional on the household’s information
set at the beginning of period t, β ∈ (0, 1) is the household’s discount factor, c
t
≥ 0 and
l
t
∈ [0,
¯
l] are the household’s choice of consumption and labor in period t, a
t
is the household’s
beginning-of-period assets, and w
t
, r
t
, and d
t
denote the real wage, interest rate, and net
4
transfer payments at time t. There is a finite-dimensional Markovian state vector θ
t
that is
exogenous to the household and governs the processes for w
t
, r
t
, and d
t
. Conditional on θ
t
,
the household knows the time-t values for w
t
, r
t
, and d
t
. The state vector and information
set of the household’s optimization problem at each date t is thus (a
t
; θ
t
).
We make the following regularity assumptions regarding the utility kernel u:
Assumption 1. The function u : R
+
× [0,
¯
l) → R,
¯
l ∈ (0, ∞], is increasing in its first
argument, decreasing in its second, twice-differentiable, and concave.
Assumption 1 guarantees the existence of a unique optimal choice for (c
t
, l
t
) at each point in
time, given (a
t
; θ
t
). Note that since u is increasing in consumption (i.e., there is no satiation),
condition (3) holds with equality at the optimum.
Let V (a
t
; θ
t
) denote the value function for the household’s optimization problem. Then
V satisfies the Bellman equation:
V (a
t
; θ
t
) = max
c
t
,l
t
u(c
t
, l
t
) + βE
t
V (a
t+1
; θ
t+1
), (4)
where a
t+1
is given by (2). Letting c

t
≡ c

(a
t
; θ
t
) and l

t
≡ l

(a
t
; θ
t
) denote the household’s
optimal choices of c
t
and l
t
as functions of the state (a
t
; θ
t
), V can be written as:
V (a
t
; θ
t
) = u(c

t
, l

t
) + βE
t
V (a

t+1
; θ
t+1
), (5)
where a

t+1
≡ (1 + r
t
)a
t
+ w
t
l

t
+ d
t
−c

t
.
To avoid having to consider boundary solutions, we make the following standard as-
sumption:
Assumption 2. For any feasible state (a
t
; θ
t
), the household’s optimal choice (c

t
, l

t
) lies in
the interior of R
+
×[0,
¯
l).
Intuitively, Assumption 2 requires the partial derivatives of u to grow sufficiently large toward
the boundary that only interior solutions for c

t
and l

t
are optimal for the set of possible
(a
t
; θ
t
) that the household may face.
Assumptions 1–2 also guarantee that V is continuously differentiable and satisfies the
Benveniste-Scheinkman equation, but we will require slightly more than this below:
Assumption 3. The value function V (·; ·) is twice-differentiable.
Assumption 3 also implies differentiability of the optimal policy functions, c

and l

. San-
tos (1991) provides relatively mild sufficient conditions for Assumption 3 to be satisfied;
intuitively, u must be strongly concave.
5
2.2 Representative Household and Steady State Assumptions
Up to this point, we have considered the case of a single household, leaving the other house-
holds of the model and the production side of the economy unspecified. Implicitly, the other
households and production sector jointly determine the process for θ
t
(and hence w
t
, r
t
,
and d
t
), and much of the analysis below does not need to be any more specific about these
processes than this. However, to move from general expressions for household risk aversion to
more concrete, closed-form expressions, we adopt two standard assumptions from the DSGE
literature.
4
Assumption 4. The household is atomistic and representative.
Assumption 4 implies that the individual household’s choices for c
t
and l
t
have no effect on
the aggregate quantities w
t
, r
t
, d
t
, and θ
t
. It also implies that, when the economy is at the
nonstochastic steady state (described shortly), any individual household finds it optimal to
choose the steady-state values of c and l given a and θ.
Assumption 5. The model has a nonstochastic steady state, or a balanced growth path that
can be renormalized to a nonstochastic steady state after a suitable change of variables. At
the nonstochastic steady state, x
t
= x
t+1
= x
t+k
for k = 1, 2, . . . , and x ∈ {c, l, a, w, r, d, θ},
and we drop the subscript t to denote the steady-state value.
It is important to note that Assumptions 4–5 do not prohibit us from offering an
individual household a hypothetical gamble of the type described below. The steady state
of the model serves only as a reference point around which the aggregate variables w, r,
d, and θ and the other households’ choices of c, l, and a can be predicted with certainty.
This reference point is important because it makes it much easier to compute closed-form
expressions for many features of the model.
2.3 The Coefficient of Absolute Risk Aversion
The household’s risk aversion at time t generally depends on the household’s state vector
at time t, (a
t
; θ
t
). Given this state, we consider the household’s aversion to a hypothetical
4
Alternative assumptions about the nature of the other households in the model or the production sector
may also allow for closed-form expressions for risk aversion. However, the assumptions used here are standard
and thus the most natural to pursue.
6
one-shot gamble in period t of the form:
a
t+1
= (1 + r
t
)a
t
+ w
t
l
t
+ d
t
−c
t
+ σε
t+1
, (6)
where ε
t+1
is a random variable with mean zero and unit variance that represents the gam-
ble.
5
A few words about (6) are in order: First, the gamble is dated t + 1 to clarify that its
outcome is not in the household’s information set at time t. Second, neither a
t
nor c
t
can be
the subject of the gamble: a
t
is a state variable known with certainty at t, and c
t
is a choice
variable under control of the household at time t. However, (6) is clearly equivalent to a
gamble over net transfers d
t
or asset returns r
t
, both of which are exogenous to the house-
hold at time t. Indeed, thinking of the gamble as being over r
t
helps clarify the connection
between (6) and asset prices, to which we will return in Section 2.6, below. As shown there,
the gamble in (6) is exactly the right framework for thinking about asset prices.
Following Arrow (1964) and Pratt (1965), we can ask what one-time fee μ the household
would be willing to pay in period t to avoid the gamble in (6):
a
t+1
= (1 + r
t
)a
t
+ w
t
l
t
+ d
t
−c
t
−μ. (7)
The quantity 2dμ/dσ
2
, for infitesimal dμ and dσ that make the household just indifferent
between (6) and (7), is the household’s coefficient of absolute risk aversion.
6
Proposition 1. The household’s coefficient of absolute risk aversion with respect to the
gamble described in (6) is given by:
−E
t
V
11
(a

t+1
; θ
t+1
)
E
t
V
1
(a

t+1
; θ
t+1
)
, (8)
where V
1
and V
11
denote the first and second partial derivatives of V with respect to its first
argument. Evaluated at the steady state, (8) simplifies to:
−V
11
(a; θ)
V
1
(a; θ)
. (9)
Proof: See Appendix.
5
The gamble ε
t+1
is assumed to be independent of the exogenous state variables θ
τ
for all times τ, and
independent of the household’s variables a
τ
, c
τ
, and l
τ
for all τ ≤ t.
6
We defer discussion of relative risk aversion until the next subsection because defining total household
wealth is complicated by the presence of human capital—that is, the household’s labor income.
7
Equations (8)–(9) are essentially Constantinides’ (1990) definition of risk aversion, and
have obvious similarities to Arrow (1964) and Pratt (1965). Here, of course, it is the curvature
of the value function V with respect to assets that matters, rather than the curvature of the
utility kernel u with respect to consumption.
7
Deriving the coefficient of absolute risk aversion in Proposition 1 is simple enough, but
the problem with (8)–(9) is that closed-form expressions for V (and hence V
1
and V
11
) do
not exist in general, even for the simplest DSGE models. This difficulty may help to explain
the popularity of “shortcut” approaches to measuring risk aversion, notably −u
11
(c

t
, l

t
)/
u
1
(c

t
, l

t
), which has no clear relationship to (8)–(9) except in the one-good one-period case.
Boldrin, Christiano, and Fisher (1997) derive closed-form solutions for V —and hence risk
aversion—for some very simple, consumption-only endowment economy models. This ap-
proach is a nonstarter for even the simplest DSGE models that include labor.
We solve this problem by observing that V
1
and V
11
often can be computed even when
closed-form solutions for V cannot be. For example, the Benveniste-Scheinkman equation:
V
1
(a
t
; θ
t
) = (1 + r
t
) u
1
(c

t
, l

t
), (10)
states that the marginal value of a dollar of assets equals the marginal utility of consumption
times 1 + r
t
(the interest rate appears here because beginning-of-period assets in the model
generate income in period t). In (10), u
1
is a known function. Although closed-form solutions
for the functions c

and l

are not known in general, the points c

t
and l

t
often are known—
for example, when they are evaluated at the nonstochastic steady state, c and l. Thus, we
can compute V
1
at the nonstochastic steady state by evaluating (10) at that point.
We compute V
11
by noting that (10) holds for general a
t
; hence we can differentiate
(10) to yield:
V
11
(a
t
; θ
t
) = (1 + r
t
)
¸
u
11
(c

t
, l

t
)
∂c

t
∂a
t
+ u
12
(c

t
, l

t
)
∂l

t
∂a
t

. (11)
All that remains is to find the derivatives ∂c

t
/∂a
t
and ∂l

t
/∂a
t
.
We solve for ∂l

t
/∂a
t
by differentiating the household’s intratemporal optimality con-
dition:
−u
2
(c

t
, l

t
) = w
t
u
1
(c

t
, l

t
), (12)
7
Arrow (1964) and Pratt (1965) occasionally refer to utility as being defined over “money”, so one could
argue that they always intended for risk aversion to be measured using indirect utility or the value function.
8
with respect to a
t
, and rearranging terms to yield:
∂l

t
∂a
t
= −λ
t
∂c

t
∂a
t
, (13)
where
λ
t

w
t
u
11
(c

t
, l

t
) + u
12
(c

t
, l

t
)
u
22
(c

t
, l

t
) + w
t
u
12
(c

t
, l

t
)
=
u
1
(c

t
, l

t
)u
12
(c

t
, l

t
) −u
2
(c

t
, l

t
)u
11
(c

t
, l

t
)
u
1
(c

t
, l

t
)u
22
(c

t
, l

t
) −u
2
(c

t
, l

t
)u
12
(c

t
, l

t
)
. (14)
Note that, if consumption and leisure in period t are normal goods, then λ
t
must be positive.
8
It now only remains to solve for the derivative ∂c

t
/∂a
t
.
Intuitively, ∂c

t
/∂a
t
should not be too difficult to compute: it is just the household’s
marginal propensity to consume today out of a change in assets, which we can deduce from
the household’s Euler equation and budget constraint. Differentiating the Euler equation:
u
1
(c

t
, l

t
) = βE
t
(1 + r
t+1
) u
1
(c

t+1
, l

t+1
), (15)
with respect to a
t
yields:
9
u
11
(c

t
, l

t
)
∂c

t
∂a
t
+ u
12
(c

t
, l

t
)
∂l

t
∂a
t
= βE
t
(1 + r
t+1
)
¸
u
11
(c

t+1
, l

t+1
)
∂c

t+1
∂a
t
+ u
12
(c

t+1
, l

t+1
)
∂l

t+1
∂a
t

(16)
Substituting in for ∂l

t
/∂a
t
gives:
(u
11
(c

t
, l

t
) −λ
t
u
12
(c

t
, l

t
))
∂c

t
∂a
t
= βE
t
(1 +r
t+1
) (u
11
(c

t+1
, l

t+1
) −λ
t+1
u
12
(c

t+1
, l

t+1
))
∂c

t+1
∂a
t
.
(17)
Evaluating (17) at steady state, β = (1 + r)
−1
, λ
t
= λ
t+1
= λ, and the u
ij
cancel, giving:
∂c

t
∂a
t
= E
t
∂c

t+1
∂a
t
= E
t
∂c

t+k
∂a
t
, k = 1, 2, . . . (18)
∂l

t
∂a
t
= E
t
∂l

t+1
∂a
t
= E
t
∂l

t+k
∂a
t
, k = 1, 2, . . . (19)
In other words, whatever the change in the household’s consumption today, it must be
the same as the expected change in consumption tomorrow, and the expected change in
consumption at each future date t + k.
10
8
We do not require this restriction in the analysis below, but intuitively we will think of λ > 0.
9
By ∂c

t+1
/∂a
t
we mean:
∂c

t+1
∂a
t
=
∂c

t+1
∂a
t+1
da

t+1
da
t
=
∂c

t+1
∂a
t+1
¸
1 + r
t+1
+ w
t
∂l

t
∂a
t

∂c

t
∂a
t

,
and analogously for ∂l

t+1
/∂a
t
, ∂c

t+2
/∂a
t
, ∂l

t+2
/∂a
t
, etc.
10
Note that this equality does not follow from the steady state assumption. For example, in a model with
internal habits, which we will consider in Section 4, the individual household’s optimal consumption response
to a change in assets increases with time, even starting from steady state.
9
The household’s budget constraint is implied by asset accumulation equation (2) and
transversality condition (3). Differentiating (2) with respect to a
t
, evaluating at steady state,
and applying (3), (18), and (19) gives:
1 + r
r
∂c

t
∂a
t
= (1 + r) +
1 + r
r
w
∂l

t
∂a
t
. (20)
That is, the expected present value of changes in household consumption must equal the
change in assets (times 1 + r) plus the expected present value of changes in labor income.
Combining (20) with (13), we can solve for ∂c

t
/∂a
t
evaluated at the steady state:
∂c

t
∂a
t
=
r
1 + wλ
. (21)
In response to a unit increase in assets, the household raises consumption in every period by
the extra asset income, r, adjusted downward by the amount 1 +wλ that takes into account
the household’s decrease in hours worked.
We can now compute the household’s coefficient of absolute risk aversion. Substituting
(10), (11), (13)–(14), and (21) into (9), we have proved:
Proposition 2. The household’s coefficient of absolute risk aversion in Proposition 1, eval-
uated at steady state, satisfies:
−V
11
(a; θ)
V
1
(a; θ)
=
−u
11
+ λu
12
u
1
r
1 + wλ
, (22)
where u
1
, u
11
, and u
12
denote the corresponding partial derivatives of u evaluated at the
steady state (c, l), and λ is given by (14) evaluated at steady state.
When there is no labor margin in the model, Proposition 2 has the following corollary:
Corollary 3. Suppose that l
t
is fixed exogenously at l ≥ 0 for all t and the household chooses
c
t
optimally at each t given this constraint. Then the household’s coefficient of absolute risk
aversion (22), evaluated at steady state, is given by:
−V
11
(a; θ)
V
1
(a; θ)
=
−u
11
u
1
r. (23)
Proof: The assumptions and steps leading up to Proposition 2, adjusted to the one-
dimensional case, are essentially the same as the above with λ
t
= 0.
Proposition 2 and Corollary 3 are remarkable. First, the household’s coefficient of ab-
solute risk aversion in (23) is just the traditional measure, −u
11
/u
1
, times r, which translates
10
assets into current-period consumption. In other words, for any utility kernel u, the tradi-
tional, static measure of risk aversion is also the correct measure in the dynamic context,
regardless of whether u or the rest of the model is homothetic, whether or not we can solve
for V , and no matter what the functional forms of u and V .
More generally, when households have a labor margin, Proposition 2 shows that risk
aversion is less than the traditional measure by the factor 1 + wλ, even when consumption
and labor are additively separable in u (i.e. u
12
= 0). Even in the additively separable
case, households can partially absorb shocks to income through changes in hours worked.
As a result, c

t
depends on household labor supply, so labor and consumption are indirectly
connected through the budget constraint. When u
12
= 0, risk aversion in Proposition 2 is
further attenuated or amplified by the direct interaction between consumption and labor in
utility, u
12
.
The household’s labor margin can have dramatic effects on risk aversion. For example,
no matter how large the traditional measure −u
11
/u
1
, the household can still be risk neutral:
Corollary 4. The household’s coefficient of absolute risk aversion (22) vanishes as the
discriminant u
11
u
22
− u
2
12
vanishes, so long as either u
1
= −u
2
or u
12
< max{|u
11
|, |u
22
|}
in the limit.
Proof: The corollary is stated as a limiting result to respect concavity in Assumption 1.
Substituting out λ and w, (22) vanishes as u
11
u
22
−u
2
12
vanishes except for the special case
u
1
= −u
2
and u
11
= −u
12
= u
22
—that is, the special case u(c, l) = ˜ u(c −l) to second order
for some function ˜ u. The corollary rules out that case by assumption.
In other words, risk aversion depends on the concavity of u in all dimensions rather
than just in one dimension. Even when u
11
is very large, the household still can be risk
neutral if u
22
is small or the cross-effect u
12
is sufficiently large. Geometrically, if there
exists any direction in (c, l)-space along which u is flat, the household will optimally choose
to absorb shocks to income along that line, resulting in risk-neutral behavior.
We provide some more concrete examples of risk aversion calculations in Section 2.5,
below, after first defining relative risk aversion.
2.4 The Coefficient of Relative Risk Aversion
The difference between absolute and relative risk aversion is the size of the hypothetical
gamble faced by the household. If the household faces a one-shot gamble of size A
t
in
11
period t, that is:
a
t+1
= (1 + r
t
)a
t
+ w
t
l
t
+ d
t
−c
t
+ A
t
σε
t+1
, (24)
or the household can pay a one-time fee A
t
μ in period t to avoid this gamble, then it follows
from Proposition 1 that the household’s coefficient of risk aversion, 2dμ/dσ
2
, for this gamble
is given by:
−A
t
E
t
V
11
(a

t+1
; θ
t+1
)
E
t
V
1
(a

t+1
; θ
t+1
)
. (25)
The natural definition of A
t
, considered by Arrow (1964) and Pratt (1965), is the household’s
wealth at time t. The gamble in (24) is then over a fraction of the household’s wealth and
(25) is referred to as the household’s coefficient of relative risk aversion.
In DSGE models, however, household wealth can be more difficult to define because of
the presence of human capital. In these models, there are two natural definitions of human
capital, so we consequently define two measures of household wealth A
t
and two coefficients
of relative risk aversion (25).
First, when the household’s time endowment is not well-defined—as when u(c
t
, l
t
) =
c
1−γ
t
/(1−γ)−l
1+χ
t
and no upper bound on l
t
is specified—it is most natural to define human
capital as the present discounted value of labor income, w
t
l

t
. Equivalently, total household
wealth A
t
equals the present discounted value of consumption, which follows from the budget
constraint (2)–(3). We state this formally as:
Definition 1. The household’s consumption-based coefficient of relative risk aversion is
given by (25), with A
t
≡ (1+r
t
)
−1
E
t
¸

τ=t
m
t,τ
c

τ
, the present discounted value of household
consumption, and where m
t,τ
denotes the stochastic discount factor β
τ−t
u
1
(c

τ
, l

τ
)/u
1
(c

t
, l

t
).
The factor (1 + r
t
)
−1
in the definition expresses wealth A
t
in beginning- rather than end-
of-period-t units, so that in steady state A = c/r and the consumption-based coefficient of
relative risk aversion is given by:
−AV
11
(a; θ)
V
1
(a; θ)
=
−u
11
+ λu
12
u
1
c
1 + wλ
. (26)
Alternatively, when the household’s time endowment
¯
l is well specified, we can define
human capital to be the present discounted value of the household’s time endowment, w
t
¯
l. In
thise case, total household wealth
˜
A
t
equals the present discounted value of leisure w
t
(
¯
l −l

t
)
plus consumption c

t
, from (2)–(3). We thus have:
12
Definition 2. The household’s leisure-and-consumption-based coefficient of relative risk
aversion is given by (25), with A
t
=
˜
A
t
≡ (1 + r
t
)
−1
E
t
¸

τ=t
m
t,τ

c

τ
+ w
τ
(
¯
l −l

τ
)

.
In steady state,
˜
A =

c + w(
¯
l − l)

/r, and the leisure-and-consumption-based coefficient of
relative risk aversion is given by:

˜
AV
11
(a; θ)
V
1
(a; θ)
=
−u
11
+ λu
12
u
1
c + w(
¯
l −l)
1 + wλ
. (27)
Of course, (26) and (27) are related by the ratio of the two gambles, (c + w(
¯
l −l))/c.
Other definitions of relative risk aversion, corresponding to alternative definitions of
wealth and the size of the gamble A
t
, are also possible, but Definitions 1–2 are the most
natural for several reasons. First, both definitions reduce to the usual present discounted
value of income or consumption when there is no human capital in the model. Second, both
measures of risk aversion reduce to the traditional −c u
11
/u
1
when there is no labor margin
in the model—that is, when λ = 0. Third, in steady state the household consumes exactly
the flow of income from its wealth, rA, consistent with standard permanent income theory
(where one must include the value of leisure w(
¯
l −l) as part of consumption when the value
of leisure is included in wealth).
We close this section by noting that neither measure of relative risk aversion is recip-
rocal to the intertemporal elasticity of substitution:
Corollary 5. Evaluated at steady state: i) the consumption-based coefficient of relative
risk aversion and intertemporal elasticity of substitution are reciprocal if and only if λ = 0;
ii) the leisure-and-consumption-based coefficient of relative risk aversion and intertemporal
elasticity of substitution are reciprocal if and only if λ = (
¯
l −l)/c.
Proof: Note that the case w = 0 is ruled out by Assumptions 1–2. The household’s
intertemporal elasticity of substitution, evaluated at steady state, is given by

dc

t+1

dc

t

/d log(1 + r
t+1
), which equals −u
1
/

c(u
11
− λu
12
)

by a calculation along the lines
of (17), holding w
t
fixed but allowing l

t
and l

t+1
to vary endogenously. The corollary follows
from comparing this expression to (26) and (27).
2.5 Examples
Some simple examples illustrate how ignoring the household’s labor margin can lead to wildly
inaccurate measures of the household’s true attitudes toward risk.
13
Example 2.1. Consider the additively separable utility kernel:
u(c
t
, l
t
) =
c
1−γ
t
1 −γ
−χ
0
l
1+χ
t
1 + χ
, (28)
where γ, χ, χ
0
> 0. The traditional measure of risk aversion for this utility kernel is
−c u
11
/u
1
= γ, but the household’s consumption-based coefficient of relative risk aversion is
given by (26):
−AV
11
V
1
=
−cu
11
u
1
1
1 + w
wu
11
u
22
=
γ
1 +
γ
χ
wl
c
. (29)
The household’s leisure-and-consumption-based coefficient of relative risk aversion (27) is
not well defined in this example (the household’s risk aversion can be made arbitrarily
large or small just by varying the household’s time endowment
¯
l), so we focus only on
the consumption-based measure (29).
In steady state, c ≈ wl,
11
so (29) can be written as:
−AV
11
V
1

1
1
γ
+
1
χ
. (30)
Note that (30) is less than the traditional measure of risk aversion by a factor of 1 + γ/χ.
Thus, if γ = 2 and χ = 1—parameter values that are well within the range of estimates in
the literature—then the household’s true risk aversion is less than the traditional measure by
a factor of about three. This point is illustrated in Figure 1, which graphs the coefficient of
relative risk aversion for this example as a function of the traditional measure, γ, for several
different values of χ. If χ is very large, then the bias from using the traditional measure is
small because household labor supply is essentially fixed.
12
However, as χ approaches 0, a
common benchmark in the literature, the bias explodes and true risk aversion approaches
zero—the household becomes risk neutral. Intuitively, households with linear disutility of
work are risk neutral with respect to gambles over wealth because they can completely offset
those gambles at the margin by working more or fewer hours, and households with linear
disutility of work are clearly risk neutral with respect to gambles over hours.
Expression (30) also helps to clarify several points. First, risk aversion in the model
is a combination of both parameters γ and χ, reflecting that the household absorbs income
11
In steady state, c = ra + wl + d, so c = wl holds exactly if there is neither capital nor transfers in the
model. In any case, ra + d is typically small for standard calibrations in the literature.
12
Similarly, if γ is very small, the bias from using the traditional measure is small because the household
chooses to absorb income shocks almost entirely along its consumption margin. As a result, the labor margin
is again almost inoperative.
14
4
5
6
7
8
9
10
c
i
e
n
t

o
f

r
e
l
a
t
i
v
e

r
i
s
k

a
v
e
r
s
i
o
n
Ȥ = 5
Ȥ =’
0
1
2
3
0 1 2 3 4 5 6 7 8 9 10
C
c
o
e
f
f
i
c
Ȗ
Ȥ =5
Ȥ =0
Ȥ =1
Ȥ =2
Ȥ =3
Ȥ =4
Figure 1. Consumption-based coefficient of relative risk aversion for the utility kernel u(c
t
, l
t
) =
c
1−γ
t
/(1−γ)−χ
0
l
1+χ
t
/(1+χ) in Example 2.1, as a function of the traditional measure γ, for different
values of χ. See text for details.
gambles along both of its margins, consumption and labor. Second, for any given γ, actual
risk aversion in the model can lie anywhere between 0 and γ, depending on χ. That is,
having an additional margin with which to absorb income gambles reduces the household’s
aversion to risk. Third, (30) is symmetric in γ and χ, reflecting that labor and consumption
enter symmetrically into u in this example and play an essentially equal role in absorbing
income shocks. Put another way, ignoring the labor margin in this example would be just
as erroneous as ignoring the consumption margin.
Example 2.2. Consider the King-Plosser-Rebelo-type (1988) utility kernel:
u(c
t
, l
t
) =
c
1−γ
t
(1 −l
t
)
χ(1−γ)
1 −γ
, (31)
where γ > 0, γ = 1, χ > 0,
¯
l = 1, and χ(1 − γ) < γ for concavity. The traditional
measure of risk aversion for (31) is γ, but the household’s actual leisure-and-consumption-
15
based coefficient of relative risk aversion is given by:

˜
AV
11
V
1
=
−u
11
+ λu
12
u
1
c + w(1 −l)
1 + wλ
= γ −χ(1 −γ). (32)
Note that concavity of (31) implies that (32) is positive. As in the previous example, (32)
depends on both γ and χ, and can lie anywhere between 0 and the traditional measure γ,
depending on χ. In this example, risk aversion is less than the traditional measure by the
amount χ(1−γ). As χ approaches γ/(1−γ)—that is, as utility approaches Cobb-Douglas—
the household becomes risk neutral; in this case, household utility along the line c
t
= w
t
(1−l
t
)
is linear, so the household finds it optimal to absorb shocks to wealth along that line.
The household’s consumption-based coefficient of relative risk aversion is a bit more
complicated than (32):
−AV
11
V
1
=
−u
11
+ λu
12
u
1
c
1 + wλ
=
γ −χ(1 −γ)
1 + χ
. (33)
Again, (33) is a combination of the parameters γ and χ, and can lie anywhere between 0
and γ, depending on χ. Neither (32) nor (33) equals the traditional measure γ, except for
the special case χ = 0.
2.6 Risk Aversion and Asset Pricing
In the preceding sections, we showed that the labor margin has important implications for
Arrow-Pratt risk aversion with respect to gambles over income or wealth. We now show that
risk aversion with respect to these gambles is also the right concept for asset pricing.
2.6.1 Measuring Risk Aversion with V As Opposed to u
Some comparison of the expressions −V
11
/V
1
and −u
11
/u
1
helps to clarify why the former
measure is the relevant one for pricing assets, such as stocks or bonds, in the model. From
Proposition 1, −V
11
/V
1
is the Arrow-Pratt coefficient of absolute risk aversion for gambles
over income or wealth in period t. In contrast, the expression −u
11
/u
1
is the risk aversion
coefficient for a hypothetical gamble in which the household is forced to consume immediately
the outcome of the gamble. Clearly, it is the former concept that corresponds to the stochastic
payoffs of a standard asset, such as a stock or bond, in a DSGE model. In order for −u
11
/u
1
to be the relevant measure for pricing a security, it is not enough that the security pay off in
16
units of consumption in period t +1. The household would additionally have to be prevented
from adjusting its consumption and labor choices in period t +1 in response to the security’s
payoffs, so that the household is forced to absorb those payoffs into period t+1 consumption.
It is difficult to imagine such a security in the real world—all standard securities in financial
markets correspond to gambles over income or wealth, for which the −V
11
/V
1
measure of
risk aversion is the appropriate one.
2.6.2 Risk Aversion, the Stochastic Discount Factor, and Risk Premia
Arrow-Pratt risk aversion, and hence the labor margin, is also closely tied to asset prices in
the standard Lucas-Breeden stochastic discounting framework.
Let m
t+1
= βu
1
(c

t+1
, l

t+1
)/u
1
(c

t
, l

t
) denote the household’s stochastic discount factor
and let p
t
denote the cum-dividend price of a risky asset at time t, with E
t
p
t+1
normalized
to unity. The percentage difference between the risk-neutral price of the asset and its actual
price—the risk premium on the asset—is given by:

E
t
m
t+1
E
t
p
t+1
−E
t
m
t+1
p
t+1

/E
t
m
t+1
= −Cov
t
(dm
t+1
, dp
t+1
)/E
t
m
t+1
(34)
where Cov
t
denotes the covariance conditional on information at time t, and dx ≡ x
t+1

E
t
x
t+1
, x ∈ {m, p}. For small changes dc

t+1
and dl

t+1
, we have, to first order:
dm
t+1
=
β
u
1
(c

t
, l

t
)

u
11
(c

t+1
, l

t+1
)dc

t+1
+ u
12
(c

t+1
, l

t+1
)dl

t+1

, (35)
conditional on information at time t. In (35), the household’s labor margin affects m
t+1
and hence asset prices for two reasons: First, if u
12
= 0, changes in l
t+1
directly affect the
household’s marginal utility of consumption. Second, even if u
12
= 0, the presence of the
labor margin affects how the household responds to shocks and hence affects dc

t+1
.
Intuitively, one can already see the relationship between risk aversion and dm
t+1
in (35):
if dl

t+1
= −λdc

t+1
and dc

t+1
= rda
t+1
/(1 + wλ), as in Section 2.3, then dm
t+1
equals the
coefficient of absolute risk aversion times da
t+1
. In actuality, the relationship is slightly
more complicated than this because θ (and hence w, r, and d) may change as well as a. For
example, differentiating (12) and evaluating at steady state, we have, to first order:
dl

t+1
= −λdc

t+1

u
1
u
22
+ wu
12
dw
t+1
, (36)
17
Similarly, combining (2), (3), and (15), differentiating, and evaluating at steady state, we
show in the Appendix that:
dc

t+1
=
r
1 + wλ
¸
da
t+1
+ E
t+1

¸
k=1
1
(1 + r)
k
(l dw
t+k
+ dd
t+k
+ adr
t+k
)

(37)
+
u
1
u
11
u
22
−u
2
12
dw
t+1
+
−ru
1
u
11
−λu
12
E
t+1

¸
k=1
1
(1 + r)
k

λ
1 + wλ
dw
t+k
−d log R
t+1,t+k

,
where R
t+1,t+k

¸
k
i=2
(1+r
t+i
). Note that for the Arrow-Pratt one-shot gamble considered
in Section 2.3, the aggregate variables w, r, and d were all held constant, so (36)–(37) reduce
to (13) and (21) in that case. The term in square brackets in (37) describes the change in
the present value of household income, and thus the first line of (37) describes the income
effect on consumption. The last line of (37) describes the substitution effect: changes in
consumption due to changes in current and future interest rates and wages. (Recall that
−u
1
/

c(u
11
−λu
12
)

is the intertemporal elasticity of substitution.)
Substituting (36)–(37) into (35) yields:
dm
t+1
= β
u
11
−λu
12
u
1
r
1 + wλ
¸
da
t+1
+ E
t+1

¸
k=1
1
(1 + r)
k
(l dw
t+k
+ dd
t+k
+ adr
t+k
)

−βr E
t+1

¸
k=1
1
(1 + r)
k

λ
1 + wλ
dw
t+k
−d log R
t+1,t+k

. (38)
The risk premium (34), evaluated at steady state, is then given by:
−u
11
+ λu
12
u
1
r
1 + wλ
Cov
t
(dp
t+1
, dA
t+1
) + r Cov
t
(dp
t+1
, dΨ
t+1
), (39)
where dA
t+1
denotes the quantity in square brackets in (38)—the change in household
wealth—and dΨ
t+1
denotes the summation on the second line of (38)—the change in cur-
rent and future wages and interest rates. Equations (38)–(39) are essentially Merton’s (1973)
ICAPM, generalized to include labor. In (39), the first term is the covariance of the asset
price with household wealth, multiplied by the coefficient of absolute risk aversion, while the
second term captures the asset’s ability to hedge what Merton calls “changes in investment
opportunities.” Intuitively, even for households that are Arrow-Pratt risk neutral, an asset
that pays off well when future interest rates are high or wages are low—and hence future
consumption is low—is preferable to an asset that has no correlation with future r or w.
Equation (39) shows the importance of risk aversion—and hence the labor margin—for
asset pricing in the model. Risk premia are essentially linear in the coefficient of absolute risk
18
aversion, a relationship which also holds for the more general cases of Epstein-Zin preferences
and habits, considered below.
13
This link between risk aversion and risk premia should not
be too surprising: Arrow-Pratt risk aversion describes the risk premium for the most basic
gambles over household income or wealth. Here we have shown that the same coefficient
also appears for completely general gambles that may be correlated with aggregate variables
such as interest rates, wages, and net transfers.
14
The risk premia on these gambles are
determined by the household’s stochastic discount factor, but the stochastic discount factor
is itself directly linked to risk aversion and the household’s labor margin.
3. Generalized Recursive Preferences
We now turn to the case of generalized recursive preferences, as in Epstein and Zin (1989) and
Weil (1989). The household’s asset accumulation equation (2) and transversality condition
(3) are the same as in Section 2, but now instead of maximizing (1), the household chooses
c
t
and l
t
to maximize the recursive expression:
15
V (a
t
; θ
t
) = max
c
t
,l
t
u(c
t
, l
t
) + β

E
t
V (a
t+1
; θ
t+1
)
1−α

1/(1−α)
, (40)
where α ∈ R, α = 1.
16
Note that (40) is the same as (4), but with the value function
“twisted” and “untwisted” by the coefficient 1 − α. When α = 0, the preferences given by
(40) reduce to the special case of expected utility.
If u ≥ 0 everywhere, then the proof of Theorem 3.1 in Epstein and Zin (1989) shows
that there exists a solution V to (40) with V ≥ 0. If u ≤ 0 everywhere, then it is natural to
let V ≤ 0 and reformulate the recursion as:
V (a
t
; θ
t
) = max
c
t
,l
t
u(c
t
, l
t
) −β

E
t
(−V (a
t+1
; θ
t+1
))
1−α

1/(1−α)
. (41)
13
See the Appendix. For an example of this linearity, see Figure 1 of Rudebusch and Swanson (2009).
14
Boldrin, Christiano, and Fisher (1997) argue that it is u
11
/u
1
rather than V
11
/V
1
that matters for the
equity premium in their Figure 2. As shown above, it is in fact V
11
/V
1
that is crucial. What explains Boldrin
et al.’s Figure 2 is that the covariance of equity prices with the short-term interest rate is not being held
constant in their model—in particular, the variance of the risk-free rate in their model changes tremendously
over the points in their Figure 2.
15
Note that, traditionally, Epstein-Zin preferences over consumption streams have been written as:
¯
V (a
t
; θ
t
) = max
c
t
¸
c
ρ
t
+ β

E
t
¯
V (a
t+1
; θ
t+1
)
¯ α

ρ/¯ α

1/ρ
,
but by setting V =
¯
V
ρ
and α = 1 − ¯ α/ρ, this can be seen to correspond to (40).
16
We exclude the case α = 1 here for simplicity.
19
The proof in Epstein and Zin (1989) also demonstrates the existence of a solution V to (41)
with V ≤ 0 in this case.
To avoid the possibility of complex numbers arising in the maximand of (40) or (41),
we restrict the range of u to be either R
+
or R

:
17
Assumption 6. Either u : R
+
×[0,
¯
l) →R
+
, or u : R
+
×[0,
¯
l) →R

.
The main advantage of generalized recursive preferences (40) is that they allow for
greater flexibility in modeling risk aversion and the intertemporal elasticity of substitution.
In (40), the intertemporal elasticity of substitution over deterministic consumption paths is
exactly the same as in (4), but the household’s risk aversion to gambles can be amplified (or
attenuated) by the additional parameter α.
3.1 Coefficients of Absolute and Relative Risk Aversion
We consider the household’s aversion to the same hypothetical gamble as in (6):
Proposition 6. With generalized recursive preferences (40) or (41), the household’s coeffi-
cient of absolute risk aversion with respect to the gamble described by (6) is given by:
−E
t
V (a

t+1
; θ
t+1
)
−α
¸
V
11
(a

t+1
; θ
t+1
) − α
V
1
(a

t+1
; θ
t+1
)
2
V (a

t+1
; θ
t+1
)

E
t
V (a

t+1
; θ
t+1
)
−α
V
1
(a

t+1
; θ
t+1
)
. (42)
Evaluated at steady state, (42) simplifies to:
−V
11
(a; θ)
V
1
(a; θ)
+ α
V
1
(a; θ)
V (a; θ)
. (43)
Proof: See Appendix.
The first term in (43) is the same as the expected utility case (9), while the second
term in (43) reflects the amplification or attenuation of risk aversion from the additional
curvature parameter α. When α = 0, (42)–(43) reduce to (8)–(9). When u ≥ 0 and hence
V ≥ 0, higher values of α correspond to greater degrees of risk aversion; when u and V ≤ 0,
the opposite is true: higher values of α correspond to lesser degrees of risk aversion.
17
Alternatively, one can restrict the domain of u to ensure u ≥ 0 or u ≤ 0; e.g., by requiring c ≥ 1 for
u(c, l) = log c + χ(
¯
l −l).
20
The household’s coefficient of relative risk aversion is given by A
t
times (42), which,
evaluated at steady state, simplifies to:
−AV
11
(a; θ)
V
1
(a; θ)
+ α
AV
1
(a; θ)
V (a; θ)
. (44)
We define the household’s total wealth A
t
based on the present discounted value of its lifetime
consumption or lifetime leisure and consumption, as in Section 2.4, and we refer to (44) as
the consumption-based or leisure-and-consumption-based coeffcient of relative risk aversion,
depending on the definition of A.
18
Expressions (43) and (44) highlight an important feature of risk aversion with general-
ized recursive preferences: it is not invariant with respect to level shifts of the utility kernel,
except for the special case of expected utility (α = 0). That is, the utility kernels u(·, ·) and
u(·, ·)+k, where k is a constant, lead to different household attitudes toward risk. The house-
hold’s preferences are invariant, however, with respect to multiplicative transformations of
the utility kernel.
When it comes to computing the risk aversion coefficients (43)–(44), expressions (10)–
(21) for V
1
, V
11
, ∂l

t
/∂a
t
, and ∂c

t
/∂a
t
continue to apply in the current context. Moreover,
V = u(c, l)

(1 −β) at the steady state. Substituting these into (43)–(44) gives:
Proposition 7. The household’s coefficient of absolute risk aversion in Proposition 6, eval-
uated at steady state, is given by:
−V
11
V
1
+ α
V
1
V
=
−u
11
+ λu
12
u
1
r
1 + wλ
+ α
r u
1
u
. (45)
The household’s consumption-based coefficient of relative risk aversion, evaluated at steady
state, is given by:
−AV
11
V
1
+ α
AV
1
V
=
−u
11
+ λu
12
u
1
c
1 + wλ
+ α
c u
1
u
. (46)
The household’s leisure-and-consumption-based coefficient of relative risk aversion, evaluated
at steady state, is given by (c + w(
¯
l −l))/c times (46).
18
Note that, with generalized recursive preferences, the household’s stochastic discount factor is given by:
βu
1
(c

t+1
, l

t+1
)
u
1
(c

t
, l

t
)


V (a

t+1
; θ
t+1
)
(E
t
V (a

t+1
; θ
t+1
)
1−α
)
1/(1−α)


−α
,
which must be used to compute household wealth. At steady state, however, this simplifies to the usual β.
21
Proposition 7 is important because risk aversion for Epstein-Zin preferences has only
been computed previously in homothetic, isoelastic, consumption-only models, where the
value function can be computed in closed form. Proposition 7 does not require homotheticity,
is valid for general functional forms u, unknown functional forms V , and allows for the
presence of labor.
3.2 Examples
Example 3.1. Consider the additively separable utility kernel:
u(c
t
, l
t
) =
c
1−γ
t
1 −γ
−χ
0
l
1+χ
t
1 + χ
, (47)
with generalized recursive preferences (41) and χ > 0, χ
0
> 0, and γ > 1, which was used by
Rudebusch and Swanson (2009).
19
In this case, where u(·, ·) < 0, risk aversion is decreasing
in α, and α < 0 corresponds to preferences that are more risk averse than expected utility.
In models without labor, period utility u(c
t
, l
t
) = c
1−γ
t
/(1 − γ) implies a coefficient
of relative risk aversion of γ + α(1 − γ), which we will refer to as the traditional mea-
sure.
20
Taking into account both the consumption and labor margins of (47), the household’s
consumption-based coefficient of relative risk aversion (46) is given by:
−AV
11
V
1
+ α
AV
1
V
=
γ
1 +
γ
χ
wl
c
+
α(1 −γ)
1 +
γ−1
1+χ
wl
c
,

γ
1 +
γ
χ
+
α(1 −γ)
1 +
γ−1
1+χ
, (48)
using c ≈ wl. As in Example 2.1, the household’s leisure-and-consumption-based coefficient
of relative risk aversion is not well defined in this example, so we restrict attention to the
consumption-based measure (48).
As χ becomes large, household labor becomes less flexible and the bias from ignoring
the labor margin shrinks to zero ((48) approaches γ +α(1 −γ)). As χ approaches zero, (48)
decreases to α(1−γ)/γ, which is close to zero if we think of γ as being small (close to unity).
19
We restrict attention here to the case γ > 1, consistent with Assumption 6. The case γ ≤ 1 can be
considered if we place restrictions on the domain of c
t
and l
t
such that u(·, ·) < 0; one can always choose
units for c
t
and l
t
such that this doesn’t represent much of a constraint in practice. Of course, one can also
consider alternative utility kernels with γ ≤ 1 for which u(·, ·) > 0.
20
Set χ
0
= 0 and λ = 0 and substitute (47) into (46). This is the case, for example, in Epstein and Zin
(1989) and Boldrin, Christiano, and Fisher (1997), which do not have labor. In models with variable labor,
Rudebusch and Swanson (2009) refer to γ + α(1 −γ) as the quasi coefficient of relative risk aversion.
22
Thus, for given values of γ and α, actual household risk aversion can lie anywhere between
about zero and γ + α(1 −γ), depending on the value of χ.
Example 3.2. Van Binsbergen et al. (2008) and Backus, Routledge, and Zin (2008) consider
generalized recursive preferences with:
u(c
t
, l
t
) =

c
ν
t
(1 −l
t
)
1−ν

1−γ
1 −γ
, (49)
where γ > 0, γ = 1, and ν ∈ (0, 1). Van Binsbergen et al. call γ + α(1 − γ) the coefficient
of relative risk aversion, while Backus et al. use γν + α(1 − γ)ν + (1 − ν), after mapping
each study’s notation over to the present paper’s. The former measure effectively treats
consumption and leisure as a single composite commodity, while the latter measure allows ν—
the importance of the labor margin—to affect the household’s attitudes toward risk.
Substituting (49) into (46), the household’s consumption-based coefficient of relative
risk aversion is:
−AV
11
V
1
+ α
AV
1
V
= γν + α(1 −γ)ν, (50)
while the leisure-and-consumption-based coefficient of relative risk aversion is:

˜
AV
11
V
1
+ α
˜
AV
1
V
= γ + α(1 −γ). (51)
The latter agrees with the Van Binsbergen et al. (2008) measure of risk aversion, while the
former is similar to (though not quite the same as) the Backus et al. (2008) measure. In this
paper, we have provided the formal justification for both measures, (50) and (51).
21
Example 3.3. Tallarini (2000) considers an alternative Epstein-Zin specification:
˜
V
t
(a
t
; θ
t
) ≡ u(c

t
, l

t
) +
β(1 + θ)
(1 −β)(1 −χ)
log E
t
exp
¸
(1 −β)(1 −χ)
1 + θ
˜
V
t+1
(a

t+1
; θ
t+1
)

, (52)
with utility kernel:
u(c
t
, l
t
) = log c
t
+ θ log(
¯
l −l
t
). (53)
We can compute the coefficient of absolute risk aversion for (52) by following along the steps
in the proof of Proposition 6, which yields:
−V
11
(a; θ)
V
1
(a; θ)

(1 −β)(1 −χ)
1 + θ
V
1
(a; θ). (54)
21
As ν → 0, w/c → ∞, so consumption becomes trivial to insure with variations in labor supply. This
explains why the consumption-based coefficient of relative risk aversion in (50) vanishes as ν →0.
23
The other steps leading up to Proposition 7 are all the same, so substituting in for V
1
and
V
11
in (54) yields a consumption-based coefficient of relative risk aversion of:
−u
11
+ λu
12
u
1
c
1 + wλ

1 −χ
1 + θ
cu
1
=
1
1 + θc

1 −χ
1 + θ
. (55)
The leisure-and-consumption-based coefficient of relative risk aversion is (1 + θ) times (55).
Both coefficients of relative risk aversion differ from the value (θ +χ)/(1 +θ) reported
by Tallarini (2000). Tallarini applies the traditional measure of risk aversion, derived in a
consumption-only model under the assumption θ = 0, to the case where θ > 0. However,
simply setting θ > 0 in the traditional measure,
−cu
11
u
1

1−χ
1+θ
cu
1
, ignores the fact that
households vary their labor in response to shocks. As a result, Tallarini’s traditional measure
overstates the household’s true aversion to risk by a factor of 1 +θ/χ, if we normalize c to 1
in (55). As θ/χ approaches zero, the labor margin becomes unimportant and this bias
disappears, but the bias can be arbitrarily large as the ratio of θ to χ increases.
4. Internal and External Habits
Many studies in macroeconomics and finance assume that households derive utility not from
consumption itself, but from consumption relative to some reference level, or habit stock.
Habits, in turn, can have substantial effects on the household’s attitudes toward risk (e.g.,
Campbell and Cochrane, 1999, Boldrin, Christiano, and Fisher, 1997). In this section, we
investigate how habits affect risk aversion in the DSGE framework.
We generalize the household’s utility kernel in this section to u(c
t
− h
t
, l
t
), where h
t
denotes the household’s reference level of consumption, or habits. We focus on an additive
rather than multiplicative specification for habits because the implications for risk aversion
are typically more interesting in the additive case. We adjust the feasible choice set for c
t
and Assumptions 1, 2, and 6 accordingly, replacing them with:
Assumption 1

. The function u is defined over (−
¯
h, ∞) × [0,
¯
l),
¯
h ≥ 0. For every t,
c
t
> h
t

¯
h. The rest of Assumption 1 applies.
Assumption 2

. For any feasible state, the household’s optimal choice (c

t
, l

t
) lies in the
interior of (−
¯
h, ∞) ×[0,
¯
l).
Assumption 6

. Either u : (−
¯
h, ∞) ×[0,
¯
l) →R
+
, or u : (−
¯
h, ∞) ×[0,
¯
l) →R

.
24
If the habit stock h
t
is external to the household (“keeping up with the Joneses” utility),
then the parameters that govern the process for h
t
can be incorporated into the exogenous
state vector θ
t
, and the analysis proceeds much as in the previous sections. However, if the
habit stock h
t
is a function of the household’s own past levels of consumption, then the state
variables of the household’s optimization problem must be augmented to include the state
variables that govern h
t
. We consider each of these cases in turn.
4.1 External Habits
When the reference consumption level h
t
in the utility kernel u(c
t
− h
t
, l
t
) is external to
the household, then the parameters that govern h
t
can be incorporated into the exogenous
state vector θ
t
and the analysis of the previous sections carries over essentially as before. In
particular, the coefficient of absolute risk aversion continues to be given by (9) in the case
of expected utility and (43) in the case of generalized recursive preferences. The household’s
intratemporal optimality condition (12) still implies:
∂l

t
∂a
t
= −λ
t
∂c

t
∂a
t
, (56)
where λ
t
is given by (14), and the household’s Euler equation (15) still implies:
∂c

t
∂a
t
= E
t
∂c

t+1
∂a
t
= E
t
∂c

t+k
∂a
t
, k = 1, 2, . . . (57)
∂l

t
∂a
t
= E
t
∂l

t+1
∂a
t
= E
t
∂l

t+k
∂a
t
, k = 1, 2, . . . (58)
evaluated at steady state. Together with the budget constraint (2)–(3), (56)–(58) imply:
∂c

t
∂a
t
=
r
1 + wλ
. (59)
The only real differences that arise relative to the case without habits is, first, that the
steady-state point at which the derivatives of u(·, ·) are evaluated is (c − h, l) rather than
(c, l), and second, that relative risk aversion confronts the household with a hypothetical
gamble over c rather than c − h, which has a tendency to make the household more risk
averse for a given functional form u(·, ·), because the stakes are effectively larger.
Example 4.1. Consider the case of expected utility with additively separable utility kernel:
u(c
t
−h
t
, l
t
) =
(c
t
−h
t
)
1−γ
1 −γ
− χ
0
l
1+χ
t
1 + χ
, (60)
25
where γ, χ, χ
0
> 0. The traditional measure of risk aversion for this example is −cu
11
/u
1
=
γc/(c −h), which exceeds γ by a factor that depends on the importance of habits relative to
consumption. The consumption-based coefficient of relative risk aversion is:
−AV
11
V
1
=
−cu
11
u
1
1
1 + w
wu
11
u
22
,
=
γc
(c −h)
1
1 +
γc
χ(c−h)
wl
c
. (61)
When there is no labor margin in the model (λ = 0), the consumption-based measure agrees
with the traditional measure. When there is a labor margin, the household’s consumption-
based coefficient of relative risk aversion (61) is less than the traditional measure by the
factor 1 +
γc
χ(c−h)
, using wl ≈ c. Ignoring the labor margin in (61) thus leads to an even
greater bias in the model with habits (h > 0) than in the model without habits (h = 0).
If γ = 2, χ = 1, and h = .8c, then the household’s true risk aversion is smaller than the
traditional measure by a factor of more than ten.
When the household has generalized recursive preferences rather than expected utility
preferences, the consumption-based coefficient of relative risk aversion for (60) is:
γc
(c −h)
1
1 +
γc
χ(c−h)
wl
c
+
α(1 −γ)c
(c −h)
1
1 +
c
(c−h)
γ−1
1+χ
wl
c
. (62)
Again, the bias from ignoring the labor margin in (62) is even greater in the model with
habits (h > 0) than without habits (h = 0).
4.2 Internal Habits
When habits are internal to the household, we must specify how the household’s actions
affect its future habits. In order to minimize notation and emphasize intuition, in the present
section we focus on the case where habits are proportional to last period’s consumption:
h
t
= bc
t−1
, (63)
b ∈ (0, 1), and we assume the household has expected utility preferences. In the Appendix,
we derive the corresopnding closed-form expressions for the more complicated case where the
habit stock evolves according to the longer-memory process:
h
t
= ρh
t−1
+ bc
t−1
, (64)
26
with ρ ∈ (−1, 1).
With internal habits, the value of h
t+1
depends on the household’s choices in period t,
so we write out the dependence of the household’s value function on h
t
explicitly:
V (a
t
, h
t
; θ
t
) = u(c

t
−h
t
, l

t
) + β

E
t
V (a

t+1
, h

t+1
; θ
t+1
)
1−α

1/(1−α)
, (65)
where c

t
≡ c

(a
t
, h
t
; θ
t
) and l

t
≡ l

(a
t
, h
t
; θ
t
) denote the household’s optimal choices for
consumption and labor in period t as functions of the household’s state vector, and a

t+1
and
h

t+1
denote the optimal stocks of assets and habits in period t + 1 that are implied by c

t
and l

t
; that is, a

t+1
≡ (1 + r
t
)a
t
+ w
t
l

t
+ d
t
−c

t
and h

t+1
≡ bc

t
.
The household’s coefficient of absolute risk aversion can be derived in the same manner
as in Propositions 1 and 6:
Proposition 8. With generalized recursive preferences (40) or (41), utility kernel u(c
t

h
t
, l
t
), and internal habits h
t
given by (63), the household’s coefficient of absolute risk aver-
sion with respect to the gamble (6) is given by:
−E
t
V (a

t+1
, h

t+1
; θ
t+1
)
−α
¸
V
11
(a

t+1
, h

t+1
; θ
t+1
) − α
V
1
(a

t+1
, h

t+1
; θ
t+1
)
2
V (a

t+1
, h

t+1
; θ
t+1
)

E
t
V (a

t+1
, h

t+1
; θ
t+1
)
−α
V
1
(a

t+1
, h

t+1
; θ
t+1
)
. (66)
Evaluated at steady state, (66) simplifies to:
−V
11
(a, h; θ)
V
1
(a, h; θ)
+ α
V
1
(a, h; θ)
V (a, h; θ)
. (67)
Proof: Essentially identical to the proof of Proposition 6.
Computing closed-form expressions for V
1
and V
11
in (67) is substantially more compli-
cated for the case of internal habits, however, because of the dynamic relationship between
the household’s current consumption and its future habits. In order to minimize notation
and simplify this derivation as much as possible, we restrict attention in the main text to the
case of expected utility preferences (α = 0). In the Appendix, we derive the corresponding
closed-form expressions for the more complicated case of generalized recursive preferences.
The household’s first-order conditions for (65) with respect to consumption and labor
(and imposing α = 0) are given by:
u
1
(c

t
−h
t
, l

t
) = βE
t
V
1
(a

t+1
, h

t+1
; θ
t+1
) − βbE
t
V
2
(a

t+1
, h

t+1
; θ
t+1
), (68)
u
2
(c

t
−h
t
, l

t
) = −βw
t
E
t
V
1
(a

t+1
, h

t+1
; θ
t+1
). (69)
27
Equation (69) is essentially the same as in the case without habits. The first-order condi-
tion (68), however, includes the future effect of consumption on habits in the second term
on the right-hand side.
Differentiating (65) with respect to its first two arguments and applying the envelope
theorem yields:
V
1
(a
t
, h
t
; θ
t
) = β(1 + r
t
) E
t
V
1
(a

t+1
, h

t+1
; θ
t+1
), (70)
V
2
(a
t
, h
t
; θ
t
) = −u
1
(c

t
−h
t
, l

t
). (71)
Equations (69) and (70) can be used to solve for V
1
in terms of current-period utility:
V
1
(a
t
, h
t
; θ
t
) = −
(1 + r
t
)
w
t
u
2
(c

t
−h
t
, l

t
), (72)
which states that the marginal value of wealth equals the marginal utility of working fewer
hours.
22
This solves for V
1
.
To solve for V
11
, differentiate (72) with respect to a
t
to yield:
V
11
(a
t
, h
t
; θ
t
) = −
(1 + r
t
)
w
t

u
12
∂c

t
∂a
t
+ u
22
∂l

t
∂a
t

, (73)
where we drop the arguments of the u
ij
to reduce notation. It now remains to solve for
∂c

t
/∂a
t
and ∂l

t
/∂a
t
, which we do in the same manner as before, except that the dynamics
of internal habits require us to solve for ∂c

τ
/∂a
t
and ∂l

τ
/∂a
t
for all dates τ ≥ t at the
same time. To better keep track of these dynamics, we henceforth let a time subscript τ ≥ t
denote a generic future date and reserve the subscript t to denote the date of the current
period—the period in which the household faces the hypothetical one-shot gamble.
We solve for ∂l

τ
/∂a
t
in terms of ∂c

τ
/∂a
t
in much the same way as without habits.
The household’s intratemporal optimality condition ((68) combined with (69)) implies:
−u
2
(c

τ
−h

τ
, l

τ
) = w
τ

u
1
(c

τ
−h

τ
, l

τ
) + bβE
τ
V
2
(a

τ+1
, h

τ+1
; θ
τ+1
)

, (74)
= w
τ
(1 −βbF) u
1
(c

τ
−h

τ
, l

τ
), (75)
where F denotes the forward operator, that is Fx
τ
≡ E
τ
x
τ+1
for any expression x dated τ.
Differentiating (75) with respect to a
t
yields:
−u
12

∂c

τ
∂a
t

∂h

τ
∂a
t

−u
22
∂l

τ
∂a
t
= w
τ
(1 −βbF)

u
11

∂c

τ
∂a
t

∂h

τ
∂a
t

+ u
12
∂l

τ
∂a
t

, (76)
22
Using the marginal utility of labor is simpler than the marginal utility of consumption in (72) because it
avoids having to keep track of future habits and the value function next period. However, in steady state it
is also true that V
1
= u
1
(1 −βb)/β, which we will use to express risk aversion in terms of u
1
and u
11
below.
28
where Fu
11
∂c

τ
/∂a
t
denotes E
τ
u
11
(c

τ+1
−h

τ+1
, l

τ+1
) ∂c

τ+1
/∂a
t
, and ∂h

τ
/∂a
t
= 0 for τ = t
since h
t
is given. Evaluating (76) at steady state and solving for ∂l

τ
/∂a
t
yields:
∂l

τ
∂a
t
= −
u
12
+ wu
11
−βbwu
11
F
u
22
+ wu
12

1 −
βbwu
12
u
22
+ wu
12
F

−1
(1 −bL)
∂c

τ
∂a
t
. (77)
where the u
ij
are evaluated at steady state, L denotes the lag operator—that is, Lx
τ
≡ x
τ−1
for any expression x dated τ—and we assume |βbwu
12
/(u
22
+ wu
12
)| < 1 in order to ensure
convergence. Note that when b = 0, (77) reduces to −
wu
11
+u
12
u
22
+wu
12
∂c

τ
∂a
t
, as in Section 2. This
solves for ∂l

τ
/∂a
t
in terms of (current and future) ∂c

τ
/∂a
t
.
As before, we solve for ∂c

τ
/∂a
t
using the household’s Euler equation and budget con-
straint. Differentiating the household’s Euler equation:
1
w
τ
u
2
(c

τ
−h

τ
, l

τ
) = βE
τ
1 + r
τ+1
w
τ+1
u
2
(c

τ+1
−h

τ+1
, l

τ+1
), (78)
with respect to a
t
and evaluating at steady state yields:
u
12

(1 + b) −F −bL

∂c

τ
∂a
t
= −u
22
(1 −F)
∂l

τ
∂a
t
. (79)
Substituting (77) into (79) yields the following difference equation for c
τ
:

u
12

u
22
+ wu
12
−βbwu
12
F

(1 + b) −F −bL


u
22
(1 −F)

u
12
+ wu
11
−βbwu
11
F

(1 −bL)

∂c

τ
∂a
t
= 0. (80)
Since FL = 1,
23
equation (80) simplifies to:
(1 −βbF)(1 −F)(1 −bL)
∂c

τ
∂a
t
= 0, (81)
which, from (79), also implies:
(1 −βbF)(1 −F)
∂l

τ
∂a
t
= 0. (82)
Equations (81) and (82) hold for all τ ≥ t, hence we can invert the (1 − βbF) operator
forward to get:
(1 −F)(1 −bL)
∂c

τ
∂a
t
= 0, (83)
(1 −F)
∂l

τ
∂a
t
= 0. (84)
23
To be precise, FLx
τ
= E
τ−1
x
τ
, but since the household evaluates these expressions from the perspective
of the initial period t, E
t
FLx
τ
= E
t
x
τ
. Formally, take the expectation of (80) at time t and then apply
E
t
FL = E
t
to get (81).
29
In other words, whatever the initial responses ∂c

t
/∂a
t
and ∂l

t
/∂a
t
are, we must have:
E
t
∂c

t+1
∂a
t
= (1 + b)
∂c

t
∂a
t
,
E
t
∂c

t+k
∂a
t
= (1 + b +· · · + b
k
)
∂c

t
∂a
t
, (85)
and E
t
∂l

t+k
∂a
t
=
∂l

t
∂a
t
, k = 1, 2, . . . (86)
evaluated at steady state. Because of habits, consumption responds only gradually to a
surprise change in wealth, asymptoting over time to its new steady-state level, but labor
moves immediately to its new steady-state level in response to surprises in wealth.
From (85), we can now solve (79) to get:
∂l

t
∂a
t
= −λ
∂c

t
∂a
t
, (87)
where
λ ≡
w(1 −βb)u
11
+ u
12
u
22
+ w(1 −βb)u
12
=
u
1
u
12
−u
2
u
11
u
1
u
22
−u
2
u
12
, (88)
and where the latter equality follows because w = −(1 −βb)
−1
u
2
/u
1
in steady state. Thus,
that (87)–(88) are essentially identical to (13)–(14).
24
Again, λ must be positive if leisure
and consumption are normal goods.
It now remains to solve for ∂c

t
/∂a
t
. From the household’s budget constraint and
condition (86), we have:
E
t

¸
τ=t
(1 + r)
−(τ−t)
∂c

τ
∂a
t
= (1 + r) + w
1 + r
r
∂l

t
∂a
t
. (89)
Substituting (85)–(87) into (89) and solving for ∂c

t
/∂a
t
yields:
∂c

t
∂a
t
=
(1 −βb)r
1 + (1 −βb)wλ
. (90)
Without habits or labor, an increase in assets would cause consumption to rise by the amount
of the income flow from the change in assets, r. The presence of habits attenuates this change
by the amount βb in the numerator of (90), and the consumption response is further attenu-
ated by the household’s change in hours worked, which is accounted for by the denominator.
24
However, unlike the model without habits, (87)–(88) only hold here in steady state.
30
Substituting (72), (73), (87), (88), and (90) into (67), we have established:
25
Proposition 9. The household’s coefficient of absolute risk aversion in Proposition 8, eval-
uated at steady state, is given by:
−V
11
V
1
=
−u
11
+ λu
12
u
1
(1 −βb)r
1 + (1 −βb)wλ
. (91)
The household’s consumption-based coefficient of relative risk aversion, evaluated at steady
state, is given by:
−AV
11
V
1
=
−u
11
+ λu
12
u
1
(1 −βb)c
1 + (1 −βb)wλ
. (92)
The household’s leisure-and-consumption-based coefficient of relative risk aversion, evaluated
at steady state, is given by (c + w(
¯
l −l))/c times (92).
Equations (91)–(92) have essentially the same form as the corresponding expressions
in the model without habits.
Example 4.2. Consider the utility kernel of example 4.1:
u(c
t
−h
t
, l
t
) =
(c
t
−h
t
)
1−γ
1 −γ
− χ
0
l
1+χ
t
1 + χ
, (93)
where γ, χ, χ
0
> 0, but now with habits h
t
= bc
t−1
internal to the household rather than
external. In thise case, the household’s consumption-based coefficient of relative risk aversion
is given by:
−AV
11
V
1
=
−cu
11
u
1
1 −βb
1 + (1 −βb)wλ
,
= γ
1 −βb
1 −b
1
1 +
γ
χ
1−βb
1−b
wl
c
,

γ
1 +
γ
χ
, (94)
where the last line uses β ≈ 1 and wl ≈ c.
The most striking feature of equation (94) is that it is independent of b, the importance
of habits. This is in sharp contrast to the case of external habits, where risk aversion is
strongly increasing in b (cf. equation (61)).
25
In order to express (91) in terms of u
1
and u
11
instead of u
2
and u
22
, we use V
1
= (1 − βb)u
1
/β and
differentiate the first-order condition:
u
1
(c

t
−h
t
, l

t
) =
1
1 + r
t
V
1
(a
t
, h
t
; θ
t
) + βbE
t
u
1
(c

t+1
−h

t+1
, l

t+1
),
with respect to a
t
to solve for V
11
using (85)–(88) and (90).
31
5. Discussion and Conclusions
The ability to vary labor supply has dramatic effects on household risk aversion and asset
prices in dynamic equilibrium models. The traditional measure of risk aversion, −cu
11
/u
1
,
ignores the household’s ability to partially offset shocks to income with changes in hours
worked. For reasonable parameterizations, the traditional measure can easily overstate risk
aversion by a factor of three or more. Indeed, households can even be risk neutral when the
traditional measure of risk aversion is far from zero. Many studies in the macroeconomics,
macro-finance, and international literatures thus may be overstating the actual degree of risk
aversion in their models by a substantial degree.
Risk aversion matters for asset pricing. Risk premia on assets computed using the
stochastic discount factor are essentially linear in the degree of risk aversion. As a result,
asset prices in DSGE models can be very different and can behave very differently depending
on how the household’s labor margin is specified. Understanding how labor supply affects
asset prices is thus important for bringing DSGE-type models closer to financial market data.
If risk aversion is measured incorrectly because the labor margin is ignored, then risk premia
in the model are also more likely to be surprising or puzzling. An extreme example of this
is when household utility has a zero discriminant—implying risk neutrality—even when the
traditional measure of risk aversion is large.
Risk neutrality itself can be a desirable feature for some applications, such as labor mar-
ket search or financial frictions. In these applications, risk neutrality allows for much simpler
or even closed-form solutions to key aspects of the model. The present paper suggests new
ways of modeling risk neutrality in a DSGE framework. The traditional approach—linearity
of utility in consumption—has undesirable implications for interest rates and consumption
growth, but the present paper shows that any utility kernel with a zero discriminant can be
used instead.
A related observation is that risk aversion and the intertemporal elasticity of substitu-
tion are nonreciprocal, even for expected utility preferences. There is a wedge between the
two concepts that depends on the household’s labor margin.
The simple, closed-form expressions for risk aversion that this paper derives, and the
methods of the paper more generally, should be useful to researchers interested in pricing any
asset—stocks, bonds, or futures, in foreign or domestic currency—within the framework of
32
dynamic equilibrium models. Since these models are a mainstay of research in academia, at
central banks, and international financial institutions, the applicability of the results should
be widespread.
33
Appendix: Mathematical Derivations
Proof of Proposition 1
For an infinitesimal fee dμ in (7), the change in household welfare (5) is given, to first order, by:
−V
1
(a
t
; θ
t
)
1 +r
t
dμ = −βE
t
V
1
(a

t+1
; θ
t+1
) dμ, (A1)
where the right-hand side of (A1) follows from the envelope theorem.
Turning now to the gamble in (6), note first that the household’s optimal choices for con-
sumption and labor in period t, c

t
and l

t
, will generally depend on the size of the gamble σ—for
example, the household may undertake precautionary saving when faced with this gamble. Thus, in
this section we write c

t
≡ c

(a
t
; θ
t
; σ) and l

t
≡ l

(a
t
; θ
t
; σ) to emphasize this dependence on σ.
Because c

t
and l

t
depend on σ, the household’s value-to-go at time t also depends on σ. We
write this dependence out explicitly as well, so that:
¯
V (a
t
; θ
t
; σ) = u(c

t
, l

t
) +βE
t
V (a

t+1
; θ
t+1
), (A2)
where a

t+1
≡ (1 + r
t
)a
t
+ w
t
l

t
+ d
t
− c

t
. Because (6) describes a one-shot gamble in period t, it
affects assets a

t+1
in period t+1 but otherwise does not affect the household’s optimization problem
from period t +1 onward; as a result, the household’s value-to-go at time t +1 is just V (a

t+1
; θ
t+1
),
which does not depend on σ except through a

t+1
. The tilde over the V on the left-hand side of (A2)
emphasizes that the form of the value function itself is different in period t due to the presence of
the one-shot gamble in that period.
Differentiating (A2) with respect to σ, the first-order effect of the gamble on household welfare
is:
¸
u
1
∂c

∂σ
+u
2
∂l

∂σ
+βE
t
V
1
· (w
t
∂l

∂σ

∂c

∂σ

t+1
)

dσ, (A3)
where the arguments of u
1
, u
2
, and V
1
are suppressed to simplify notation. Optimality of c

t
and
l

t
implies that the terms involving ∂c

/∂σ and ∂l

/∂σ in (A3) cancel, as in the usual envelope
theorem (these derivatives vanish at σ = 0 anyway, for the reasons discussed below). Moreover,
E
t
V
1
(a

t+1
; θ
t+1

t+1
= 0 because ε
t+1
is independent of θ
t+1
and a

t+1
, evaluating the latter at
σ = 0. Thus, the first-order cost of the gamble is zero, as in Arrow (1964) and Pratt (1965).
To second order, the effect of the gamble on household welfare is:
¸
u
11

∂c

∂σ

2
+ 2u
12
∂c

∂σ
∂l

∂σ
+u
22

∂l

∂σ

2
+u
1

2
c

∂σ
2
+ u
2

2
l

∂σ
2
+βE
t
V
11
·

w
t
∂l

∂σ

∂c

∂σ

t+1

2
+ βE
t
V
1
·

w
t

2
l

∂σ
2


2
c

∂σ
2

¸

2
2
. (A4)
The terms involving ∂
2
c

/∂σ
2
and ∂
2
l

/∂σ
2
cancel due to the optimality of c

t
and l

t
. The derivatives
∂c

/∂σ and ∂l

/∂σ vanish at σ = 0 (there are two ways to see this: first, the linearized version
of the model is certainty equivalent; alternatively, the gamble in (6) is isomorphic for positive and
negative σ, hence c

and l

must be symmetric about σ = 0, implying the derivatives vanish). Thus,
for infinitesimal gambles, (A4) simplifies to:
βE
t
V
11
(a

t+1
; θ
t+1
) ε
2
t+1

2
2
. (A5)
Finally, ε
t+1
is independent of θ
t+1
and a

t+1
, evaluating the latter at σ = 0. Since ε
t+1
has unit
variance, (A5) reduces to:
βE
t
V
11
(a

t+1
; θ
t+1
)

2
2
. (A6)
34
Equating (A1) to (A6), the Arrow-Pratt coefficient of absolute risk aversion, 2dμ/dσ
2
, is:
−E
t
V
11
(a

t+1
; θ
t+1
)
E
t
V
1
(a

t+1
; θ
t+1
)
. (A7)
Recall that (A7) is already evaluated at σ = 0, so to evaluate it at the nonstochastic steady
state, set a
t+1
= a and θ
t+1
= θ to get:
−V
11
(a; θ)
V
1
(a; θ)
. (A8)
Derivation of Risk Aversion, the Stochastic Discount Factor, and Risk Premia
Differentiating the household’s Euler equation (15) and evaluating at steady state yields:
u
11
(dc

t
−E
t
dc

t+1
) +u
12
(dl

t
−E
t
dl

t+1
) = βE
t
u
1
dr
t+1
, (A9)
which, applying (36), becomes:
(u
11
−λu
12
)(dc

t
−E
t
dc

t+1
) −
u
1
u
12
u
22
+wu
12
(dw
t
−E
t
dw
t+1
) = βE
t
u
1
dr
t+1
. (A10)
Note that (A10) implies, for each k = 1, 2, . . .,
E
t
dc

t+k
= dc

t

u
1
u
12
u
11
u
22
−u
2
12
(dw
t
−E
t
dw
t+k
) −
βu
1
u
11
−λu
12
E
t
k
¸
i=1
dr
t+i
. (A11)
Combining (2)–(3), differentiating, and evaluating at steady state yields:
E
t

¸
k=0
1
(1 +r)
k
(dc

t+k
−wdl

t+k
−ldw
t+k
−dd
t+k
−adr
t+k
) = (1 + r) da
t
. (A12)
Substituting (36) and (A11) into (A12), and solving for dc

t
, yields:
dc

t
=
r
1 + r
1
1 + wλ
¸
(1 +r)da
t
+E
t

¸
k=0
1
(1 +r)
k
(l dw
t+k
+ dd
t+k
+adr
t+k
)
¸
+
u
1
u
12
u
11
u
22
−u
2
12
dw
t
+
r
1 +r
−u
1
u
11
−λu
12
E
t

¸
k=0
1
(1 +r)
k
¸
λ
1 +wλ
dw
t+k
−d log R
t,t+k

, (A13)
where R
t,t+k

¸
k
i=1
(1 +r
t+i
). Combining (35), (36), and (A13) gives:
dm
t+1
= βr
u
11
−λu
12
u
1
1
1 +wλ
¸
da
t+1
+E
t+1

¸
k=1
1
(1 +r)
k
(l dw
t+k
+dd
t+k
+adr
t+k
)
¸
−βr E
t+1

¸
k=1
1
(1 +r)
k
¸
λ
1 + wλ
dw
t+k
−d log R
t+1,t+k

, (A14)
as in the main text. Equation (A14) also holds for the case of external habits (cf. Section 4.1).
For generalized recursive preferences, equations (A9)–(A13) still hold, but dm
t+1
has extra
terms related to dV
t+1
. In this case, we get the more general expression:
dm
t+1
= βr

u
11
−λu
12
u
1
1
1 +wλ

αu
1
u

¸
da
t+1
+E
t+1

¸
k=1
1
(1 +r)
k
(l dw
t+k
+dd
t+k
+adr
t+k
)
¸
−βr E
t+1

¸
k=1
1
(1 +r)
k
¸
λ
1 +wλ
dw
t+k
−d log R
t+1,t+k

. (A15)
35
Proof of Proposition 6
For generalized recursive preferences, the hypothetical one-shot gamble and one-time fee faced by
the household are the same as for the case of expected utility. However, the household’s optimality
conditions for c

t
and l

t
(and, implicitly, a

t+1
) are slightly more complicated:
u
1
(c

t
, l

t
) = β(E
t
V (a

t+1
; θ
t+1
)
1−α
)
α/(1−α)
E
t
V (a

t+1
; θ
t+1
)
−α
V
1
(a

t+1
; θ
t+1
), (A16)
u
2
(c

t
, l

t
) = −βw
t
(E
t
V (a

t+1
; θ
t+1
)
1−α
)
α/(1−α)
E
t
V (a

t+1
; θ
t+1
)
−α
V
1
(a

t+1
; θ
t+1
). (A17)
Note that (A16) and (A17) are related by the usual u
2
(c

t
, l

t
) = −w
t
u
1
(c

t
; l

t
), and when α = 0,
(A16) and (A17) reduce to the standard optimality conditions for expected utility.
For an infinitesimal fee dμ in (7), the change in welfare for the household with generalized
recursive preferences is:
−V
1
(a
t
; θ
t
)

1 +r
t
= −β(E
t
V (a

t+1
; θ
t+1
)
1−α
)
α/(1−α)
E
t
V (a

t+1
; θ
t+1
)
−α
V
1
(a

t+1
; θ
t+1
) dμ, (A18)
where the right-hand side of (A18) follows from the envelope theorem.
Turning now to the gamble in (6), the first-order effect of the gamble on household welfare is:
¸
u
1
∂c

∂σ
+u
2
∂l

∂σ
+β(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
1
· (w
t
∂l

∂σ

∂c

∂σ

t+1
)

dσ, (A19)
where we have dropped the arguments of u
1
, u
2
, V , and V
1
to simplify notation. As before, optimality
of c

t
and l

t
implies that the terms involving ∂c

/∂σ and ∂l

/∂σ cancel, and E
t
V
−α
V
1
ε
t+1
= 0
because ε
t+1
is independent of θ
t+1
and a

t+1
, evaluating the latter at σ = 0. Thus, the first-order
cost of the gamble is zero.
To second order, the effect of the gamble on household welfare is:



u
11

∂c

∂σ

2
+ 2u
12
∂c

∂σ
∂l

∂σ
+u
22

∂l

∂σ

2
+ u
1

2
c

∂σ
2
+u
2

2
l

∂σ
2
+αβ(E
t
V
1−α
)
(2α−1)/(1−α)
¸
E
t
V
−α
V
1
·

w
t
∂l

∂σ

∂c

∂σ

t+1

2
−αβ(E
t
V
1−α
)
α/(1−α)
E
t
V
−α−1
¸
V
1
·

w
t
∂l

∂σ

∂c

∂σ

t+1

2
+β(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
11
·

w
t
∂l

∂σ

∂c

∂σ

t+1

2
+β(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
1
·

w
t

2
l

∂σ
2


2
c

∂σ
2





2
2
. (A20)
The derivatives ∂c

/∂σ and ∂l

/∂σ vanish at σ = 0, the terms involving ∂
2
c

/∂σ
2
and ∂
2
l

/∂σ
2
cancel due to the optimality of c

t
and l

t
, and ε
t+1
is independent of θ
t+1
and a

t+1
(evaluating the
latter at σ = 0). Thus, (A20) simplifies to:
β(E
t
V
1−α
)
α/(1−α)

E
t
V
−α
V
11
−αE
t
V
−α−1
V
2
1


2
2
. (A21)
Equating (A18) to (A21), the Arrow-Pratt coefficient of absolute risk aversion is:
−E
t
V
−α
V
11
+αE
t
V
−α−1
V
2
1
E
t
V
−α
V
1
. (A22)
Since (A22) is already evaluated at σ = 0, to evaluate it at the nonstochastic steady state,
set a
t+1
= a, θ
t+1
= θ to get:
−V
11
(a; θ)
V
1
(a; θ)

V
1
(a; θ)
V (a; θ)
. (A23)
36
Derivation of Risk Aversion with Long-Memory Internal Habits and EZ Preferences
We consider here the case of generalized recursive preferences:
V (a
t
, h
t
; θ
t
) = u(c

t
−h
t
, l

t
) +β

E
t
V (a

t+1
, h

t+1
; θ
t+1
)
1−α

1/(1−α)
, (A24)
and a longer-memory specification for habits:
h
t
= ρh
t−1
+bc
t−1
, (A25)
with |ρ| < 1, and we assume ρ +b < 1 in order to ensure h < c.
We wish to compute V
1
and V
11
. The household’s first-order conditions for (A24) with respect
to consumption and labor are given by:
u
1
= β(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
[V
1
−bV
2
], (A26)
u
2
= −βw
t
(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
1
, (A27)
where we drop the arguments of u and V to reduce notation. Equations (A26) and (A27) are the
same as in the main text except that the discounting of future periods involves the value function
V when α = 0.
Differentiating (A24) with respect to its first two arguments and applying the envelope theorem
yields:
V
1
= β(1 +r
t
) (E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
1
, (A28)
V
2
= −u
1
+ ρβ(E
t
V
1−α
)
α/(1−α)
E
t
V
−α
V
2
. (A29)
As in the main text, (A27) and (A28) can be used to solve for V
1
in terms of current-period
utility:
V
1
(a
t
, h
t
; θ
t
) = −
(1 +r
t
)
w
t
u
2
(c

t
−h
t
, l

t
). (A30)
To solve for V
11
, differentiate (A30) with respect to a
t
to yield:
V
11
(a
t
, h
t
; θ
t
) = −
(1 +r
t
)
w
t

u
12
∂c

t
∂a
t
+u
22
∂l

t
∂a
t

, (A31)
It remains to solve for ∂c

t
/∂a
t
and ∂l

t
/∂a
t
. As in the main text, we solve for ∂c

τ
/∂a
t
and ∂l

τ
/∂a
t
for all dates τ ≥ t at the same time. We henceforth let a time subscript τ ≥ t denote a generic
future date and reserve the subscript t to denote the date of the current period—the period in which
the household faces the hypothetical one-shot gamble.
We solve for ∂l

τ
/∂a
t
in terms of ∂c

τ
/∂a
t
in the same manner as in the main text, except
that the expressions are more complicated due to the persistence of habits and the household’s more
complicated discounting of future periods. Note first that (A29) can be used to solve for V
2
in terms
of current and future marginal utility:
V
2
= −(1 −ρβF)
−1
u
1
, (A32)
where now F denotes the “generalized recursive” forward operator; that is,
Fx
τ
≡ (E
τ
V
1−α
)
α/(1−α)
E
τ
V
−α
x
τ+1
. (A33)
The household’s intratemporal optimality condition ((A28) combined with (A29)) implies:
−u
2
(c

τ
−h

τ
, l

τ
) = w
τ
[u
1
(c

τ
−h

τ
, l

τ
) + bβE
τ
V
2
(a

τ+1
, h

τ+1
; θ
τ+1
)]. (A34)
= w
τ
(1 −βbF(1 −βρF)
−1
) u
1
(c

τ
−h

τ
, l

τ
), (A35)
37
Differentiating (A35) with respect to a
t
and evaluating at steady state yields:
−u
12

∂c

τ
∂a
t

∂h

τ
∂a
t

−u
22
∂l

τ
∂a
t
= w(1 −βbF(1 −βρF)
−1
)
¸
u
11

∂c

τ
∂a
t

∂h

τ
∂a
t

+u
12
∂l

τ
∂a
t

, (A36)
where we have used the fact that:

∂a
t
Fx
τ
= F
∂x
τ
∂a
t
, (A37)
when the derivative is evaluated at steady state. Solving (A36) for ∂l

τ
/∂a
t
yields:
∂l

τ
∂a
t
= −
u
12
+wu
11
−β(ρu
12
+ (ρ +b)wu
11
)F
u
22
+ wu
12
×
¸
1 −
β(ρu
22
+ (ρ +b)wu
12
)
u
22
+wu
12
F

−1
(1 −bL(1 −ρL)
−1
)
∂c

τ
∂a
t
. (A38)
where we’ve used h
τ
= bL(1 − ρL)
−1
c
τ
and we assume

β(ρu
22
+ (ρ +b)wu
12
)/(u
22
+wu
12
)

< 1
to ensure convergence. This solves for ∂l

t
/∂a
t
in terms of (current and future) ∂c

τ
/∂a
t
.
We now turn to solving for ∂c

τ
/∂a
t
. The household’s intertemporal optimality (Euler) con-
dition is given by:
1
w
τ
u
2
(c

τ
−h

τ
, l

τ
) = βF
1 +r
τ
w
τ
u
2
(c

τ
−h

τ
, l

τ
). (A39)
Differentiating (A39) with respect to a
t
and evaluating at steady state yields:
u
12
(1 −F) [1 −bL(1 −ρL)
−1
]
∂c

τ
∂a
t
= −u
22
(1 −F)
∂l

τ
∂a
t
. (A40)
Using (A38) and noting FL = 1 at steady state, (A40) simplifies to:
[1 −β(ρ +b)F] (1 −F) [1 −bL(1 −ρL)
−1
]
∂c

τ
∂a
t
= 0, (A41)
which, from (A40), also implies:
[1 −β(ρ +b)F] (1 −F)
∂l

τ
∂a
t
= 0. (A42)
Equations (A41) and (A42) hold for all τ ≥ t, hence we can invert the [1 − β(ρ + b)F] operator
forward to get:
(1 −F) [1 −bL(1 −ρL)
−1
]
∂c

τ
∂a
t
= 0, (A43)
(1 −F)
∂l

τ
∂a
t
= 0. (A44)
Finally, we can apply (1 −ρL) to both sides of (A43) to get:
(1 −F) [1 −(ρ +b)L]
∂c

τ
∂a
t
= 0, (A45)
which then holds for all τ ≥ t + 1. Thus, whatever the initial responses ∂c

t
/∂a
t
and ∂l

t
/∂a
t
, we
must have:
E
t
∂c

t+1
∂a
t
= (1 +b)
∂c

t
∂a
t
,
E
t
∂c

t+k
∂a
t
= (1 +b(ρ + b)
k−1
)
∂c

t
∂a
t
, (A46)
and E
t
∂l

t+k
∂a
t
=
∂l

t
∂a
t
, k = 1, 2, . . . (A47)
38
Consumption responds gradually to a surprise change in wealth, while labor moves immediately to
its new steady-state level.
From (A46), we can now solve (A40) to get:
∂l

t
∂a
t
= −λ
∂c

t
∂a
t
. (A48)
where
λ ≡
w(1 −β(ρ +b))u
11
+ (1 −βρ)u
12
(1 −βρ)u
22
+ w(1 −β(ρ +b))u
12
=
u
1
u
12
−u
2
u
11
u
1
u
22
−u
2
u
12
, (A49)
where the latter equaltiy follows because w = −
u
2
u
1
1−βρ
1−β(ρ+b)
in steady state.
It remains to solve for ∂c

t
/∂a
t
. The household’s intertemporal budget constraint implies:
E
t

¸
τ=t
(1 +r)
−(τ−t)
∂c

τ
∂a
t
= (1 +r) + w
1 +r
r
∂l

t
∂a
t
. (A50)
Substituting (A46) and (A48) into (A50) and solving for ∂c

t
/∂a
t
yields:
∂c

t
∂a
t
=
(1 −
βb
1−βρ
) r
1 + (1 −
βb
1−βρ
)wλ
. (A51)
Without habits or labor, an increase in assets would cause consumption to rise by the amount of the
income flow from the change in assets—the first term on the right-hand side of (A51). The presence
of habits attenuates this change by the amount βb/(1 − βρ) in the numerator of the second term,
and the consumption response is further attenuated by the household’s change in hours worked,
which is accounted for by the denominator of the second term in (A51).
Together, (A48) and (A51) allow us to compute the household’s coefficient of absolute risk
aversion (63) in Proposition 7:
26
−V
11
V
1

V
1
V
=
−u
11
+λu
12
u
1
(1 −
βb
1−βρ
) r
1 +(1 −
βb
1−βρ
)wλ
+ α
r u
1
u

1 −
βb
1 −βρ

. (A52)
The consumption-based coefficient of relative risk aversion is given by:
−AV
11
V
1
+ α
AV
1
V
=
−u
11
+λu
12
u
1
(1 −
βb
1−βρ
) c
1 +(1 −
βb
1−βρ
)wλ
+ α
c u
1
u

1 −
βb
1 −βρ

. (A53)
Equations (A52) and (A53) have obvious similarities to the corresponding expressions without habits
and with expected utility preferences.
26
In order to express (A52) in terms of u
1
and u
11
instead of u
2
and u
22
, we use V
1
= (1−β(ρ+b))u
1
/(β(1−
βρ)) and differentiate the first-order condition:
V
1
(a
t
, h
t
; θ
t
) = (1 + r
t
) (1 −βbF(1 −βρF)
−1
) u
1
(c

τ
−h
τ
, l

τ
),
with respect to a
t
to solve for V
11
.
39
References
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Essays in the Theory of Risk Bearing, ed. Arrow, Kenneth (Chicago: Markum, 1971).
Backus, David, Bryan Routledge, and Stanley Zin. “Asset Prices in Business Cycle Analysis,”
unpublished manuscript (2008), Tepper School of Business, Carnegie Mellon University.
Benveniste, L.M., and J.A. Scheinkman. “On the Differentiability of the Value Function in
Dynamic Models of Economics,” Econometrica 47 (1979), 727–32.
Bernanke, Ben, Mark Gertler, and Simon Gilchrist. “The Financial Accelerator in a Quan-
titative Business Cycle Framework,” Handbook of Macroeconomics 1 (1999), 1341–93.
Boldrin, Michele, Lawrence Christiano, and Jonas Fisher. “Habit Persistence and Asset
Returns in an Exchange Economy,” Macroeconomic Dynamics 1 (1997), 312–32.
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turns, and the Business Cycle,” American Economic Review 91 (2001), 149–66.
Campbell, John and John Cochrane. “By Force of Habit: A Consumption-Based Explanation
of Aggregate Stock Market Behavior,” Journal of Political Economy 107 (1999), 205–51.
Constantinides, George. “Habit Formation: A Resolution of the Equity Premium Puzzle,” Jour-
nal of Political Economy 98 (1990), 519–43.
Epstein, Larry and Stanley Zin. “Substitution, Risk Aversion, and the Temporal Behavior of
Consumption and Asset Returns: A Theoretical Framework,” Econometrica 57 (1989), 937–69.
Kihlstrom, Richard and Leonard Mirman. “Risk Aversion with Many Commodities,” Journal
of Economic Theory 8 (1974), 361–88.
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Cycles I: The Basic Neoclassical Model,” Journal of Monetary Economics 21 (1988), 195–232.
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87.
Mortensen, Dale, and Christopher Pissarides. “Job Creation and Job Destruction in the
Theory of Unemployment,” Review of Economic Studies 61 (1994), 397–415.
Pratt, John. “Risk Aversion in the Small and in the Large,” Econometrica 32 (1964), 122–36.
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Model,” Journal of Monetary Economics 55 (2008), 111–26.
Rudebusch, Glenn, and Eric Swanson. “The Bond Premium in a DSGE Model with Long-Run
Real and Nominal Risks,” Federal Reserve Bank of SF Working Paper 2008–31 (2009).
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metrica 59 (1991), 1365–82.
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660–7.
Tallarini, Thomas. “Risk-Sensitive Business Cycles,” Journal of Monetary Economics 45 (2000),
507–32.
Van Binsbergen, Jules, Jesus Fernandez-Villaverde, Ralph Koijen, and Juan Rubio-
Ramirez. “Working with Epstein-Zin Preferences: Computation and Likelihood Estimation of
DSGE Models with Recursive Preferences,” unpublished manuscript (2008).
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Economics 24 (1989), 401–21.

1

1. Introduction
In a static, one-period model with household utility u(·) defined over a single consumption good, Arrow (1964) and Pratt (1965) defined the coefficients of absolute and relative risk aversion, −u (c)/u (c) and −c u (c)/u (c). Difficulties immediately arise, however, when one attempts to generalize these concepts to the case of many periods or many goods (e.g., Kihlstrom and Mirman, 1974). These difficulties are particularly pronounced in a dynamic equilibrium model with labor, in which there is a double infinity of goods to consider— consumption and labor in every future period and state of nature—all of which may vary in response to a typical shock to household income or wealth. The present paper shows how to compute risk aversion in dynamic equilibrium models in general. First, we verify that risk aversion depends on the partial derivatives of the household’s value function V with respect to wealth a—that is, the coefficients of absolute and relative risk aversion are essentially −Vaa /Va and −aVaa /Va , respectively. Even though closed-form solutions for the value function do not exist in general, we nevertheless can derive simple, closed-form expressions for risk aversion because derivatives of the value function are much easier to compute than the value function itself. For example, in many DSGE models the derivative of the value function with respect to wealth equals the current-period marginal utility of consumption (Benveniste and Scheinkman, 1979). The main result of the paper is that the household’s labor margin has substantial effects on risk aversion, and hence asset prices. Even when labor and consumption are additively separable in utility, they remain connected by the household’s budget constraint: in particular, the household can absorb income shocks either through changes in consumption, changes in hours worked, or some combination of the two. This ability to absorb shocks along either or both margins greatly alters the household’s attitudes toward risk. For example, if the household’s utility kernel is given by u(ct , lt ) = c1−γ /(1 − γ) − χlt , the quantity t −c u11 /u1 = γ is often referred to as the household’s coefficient of relative risk aversion, but in fact the household is risk neutral with respect to gambles over income or wealth—the proper measure of risk aversion for asset pricing, as we show in Section 2. Intuitively, the household is indifferent at the margin between using labor or consumption to absorb a shock to income or wealth, and the household in this example is clearly risk neutral with respect to
1+χ gambles over hours. More generally, when u(ct , lt ) = c1−γ /(1−γ)−χ0 lt /(1+χ), risk avert

2 sion equals (γ −1 + χ−1 )−1 , a combination of the parameters on the household’s consumption and labor margins, reflecting that the household absorbs shocks using both margins.1 While modeling risk neutrality is not a main goal of the present paper, risk neutrality nevertheless can be a desirable feature for some applications, such as labor market search or financial frictions, since it allows for closed-form solutions to key features of the model.2 A contribution of the present paper is to show ways to model risk neutrality that do not require utility to be linear in consumption, which has undesirable implications for interest rates and consumption growth. Instead, any utility kernel with zero discriminant can be used. A final result of the paper is that risk premia computed using the Lucas-Breeden stochastic discounting framework are essentially linear in risk aversion. That is, measuring risk aversion correctly—taking into account the household’s labor margin—is necessary for understanding asset prices in the model. Since much recent research has focused on bringing dynamic stochastic general equilibrium (DSGE) models into closer agreement with asset prices,3 it is surprising that so little attention has been paid to measuring risk aversion correctly in these models. The present paper aims to fill that void. There are a few previous studies that extend the Arrow-Pratt definition beyond the one-good, one-period case. In a static, multiple-good setting, Stiglitz (1969) measures risk aversion using the household’s indirect utility function rather than utility itself, essentially a special case of Proposition 1 of the present paper. Constantinides (1990) measures risk aversion in a dynamic, consumption-only (endowment) economy using the household’s value function, another special case of Proposition 1. Boldrin, Christiano, and Fisher (1997) apply Constantinides’ definition to some very simple endowment economy models for which they can compute closed-form expressions for the value function, and hence risk aversion. The present paper builds on these studies by deriving closed-form solutions for risk aversion in dynamic equilibrium models in general, demonstrating the importance of the labor margin, and showing the tight link between risk aversion and asset prices in these models.
Note that the intertemporal elasticity of substitution in this example is still 1/γ, so a corollary of this result is that risk aversion and the intertemporal elasticity of substitution are nonreciprocal when labor supply can vary.
2 3 1

See, e.g., Mortensen and Pissarides (1994), and Bernanke, Gertler, and Gilchrist (1999).

See, e.g., Boldrin, Christiano, and Fisher (2001), Tallarini (2000), Rudebusch and Swanson (2008, 2009), Van Binsbergen, Fernandez-Villaverde, Koijen, and Rubio-Ramirez (2008), and Backus, Routledge, and Zin (2009).

3 The remainder of the paper proceeds as follows. Section 2 presents the main ideas of the paper, deriving Arrow-Pratt risk aversion in dynamic equilibrium models for the timeseparable expected utility case and demonstrating the importance of risk aversion for asset pricing. Section 3 extends the analysis to the case of generalized recursive preferences (Epstein and Zin, 1989), which have been the focus of much recent research at the boundary between macroeconomics and finance. Section 4 extends the analysis to the case of internal and external habits, two of the most common intertemporal nonseperabilities in preferences in both the macroeconomics and finance literatures. Section 5 discusses some general implications and concludes. An Appendix provides details of derivations and proofs that are outlined in the main text.

2. Time-Separable Expected Utility Preferences
To highlight the intuition and methods of the paper, we consider first the case where the household has additively time-separable expected utility preferences.

2.1 The Household’s Optimization Problem and Value Function
Time is discrete and continues forever. At each time t, the household seeks to maximize the expected present discounted value of utility flows:

Et
τ =t

β τ −t u(cτ , lτ ),

(1)

subject to the sequence of asset accumulation equations: aτ +1 = (1 + rτ )aτ + wτ lτ + dτ − cτ , and transversality condition:
T T →∞

τ = t, t + 1, . . .

(2)

lim

(1 + rτ +1 )−1 aT +1 ≥ 0,

(3)

τ =t

where Et denotes the mathematical expectation conditional on the household’s information set at the beginning of period t, β ∈ (0, 1) is the household’s discount factor, ct ≥ 0 and l] lt ∈ [0, ¯ are the household’s choice of consumption and labor in period t, at is the household’s beginning-of-period assets, and wt , rt , and dt denote the real wage, interest rate, and net

Assumption 1 guarantees the existence of a unique optimal choice for (ct . Santos (1991) provides relatively mild sufficient conditions for Assumption 3 to be satisfied. Conditional on θt . decreasing in its second. . given (at . V can be written as: ∗ V (at . Letting c∗ ≡ c∗ (at . lt ) at each point in time. and dt . The state vector and information set of the household’s optimization problem at each date t is thus (at .e. intuitively. is increasing in its first argument. there is no satiation). θt ) that the household may face. t+1 t (5) To avoid having to consider boundary solutions. Assumptions 1–2 also guarantee that V is continuously differentiable and satisfies the Benveniste-Scheinkman equation. lt ) + βEt V (a∗ . ¯ ∈ (0. The value function V (·. Assumption 2 requires the partial derivatives of u to grow sufficiently large toward ∗ the boundary that only interior solutions for c∗ and lt are optimal for the set of possible t (at . θt+1 ). ∞]. θt ) denote the value function for the household’s optimization problem. u must be strongly concave. The function u : R+ × [0. ¯ → R. lt ) + βEt V (at+1 . but we will require slightly more than this below: Assumption 3. θt ) = max u(ct . θt ) = u(c∗ . we make the following standard assumption: ∗ Assumption 2.lt (4) ∗ where at+1 is given by (2). θt ). θt ). and dt . θt+1 ). the household’s optimal choice (c∗ . ct . For any feasible state (at . Then V satisfies the Bellman equation: V (at . Let V (at . the household knows the time-t values for wt . Note that since u is increasing in consumption (i. condition (3) holds with equality at the optimum. rt . twice-differentiable. We make the following regularity assumptions regarding the utility kernel u: l) l Assumption 1. θt ) denote the household’s t optimal choices of ct and lt as functions of the state (at . rt . θt ). lt ) lies in t the interior of R+ × [0. ¯ l). t t+1 ∗ where a∗ ≡ (1 + rt )at + wt lt + dt − c∗ . θt ) and lt ≡ l∗ (at .4 transfer payments at time t. ·) is twice-differentiable. Intuitively. and concave. There is a finite-dimensional Markovian state vector θt that is exogenous to the household and governs the processes for wt . Assumption 3 also implies differentiability of the optimal policy functions. θt ). c∗ and l∗ ..

the other households and production sector jointly determine the process for θt (and hence wt . xt = xt+1 = xt+k for k = 1. and dt ). Assumption 4 implies that the individual household’s choices for ct and lt have no effect on the aggregate quantities wt . . At the nonstochastic steady state. closed-form expressions. 2. and x ∈ {c. the assumptions used here are standard and thus the most natural to pursue. l.5 2. and θt . However. This reference point is important because it makes it much easier to compute closed-form expressions for many features of the model. It also implies that. r. However. r. The model has a nonstochastic steady state. and much of the analysis below does not need to be any more specific about these processes than this. l. θt ). It is important to note that Assumptions 4–5 do not prohibit us from offering an individual household a hypothetical gamble of the type described below. . Implicitly. The steady state of the model serves only as a reference point around which the aggregate variables w. . 2. leaving the other households of the model and the production side of the economy unspecified. d. (at .4 Assumption 4. rt . rt . The household is atomistic and representative. d. Given this state. when the economy is at the nonstochastic steady state (described shortly). and a can be predicted with certainty. we adopt two standard assumptions from the DSGE literature. we have considered the case of a single household. we consider the household’s aversion to a hypothetical Alternative assumptions about the nature of the other households in the model or the production sector may also allow for closed-form expressions for risk aversion. and θ and the other households’ choices of c. or a balanced growth path that can be renormalized to a nonstochastic steady state after a suitable change of variables.2 Representative Household and Steady State Assumptions Up to this point. 4 . to move from general expressions for household risk aversion to more concrete. dt . w. .3 The Coefficient of Absolute Risk Aversion The household’s risk aversion at time t generally depends on the household’s state vector at time t. Assumption 5. any individual household finds it optimal to choose the steady-state values of c and l given a and θ. and we drop the subscript t to denote the steady-state value. a. θ}.

is the household’s coefficient of absolute risk aversion.θ Et V1 (at+1 t+1 ) (8) where V1 and V11 denote the first and second partial derivatives of V with respect to its first argument. V1 (a. and lτ for all τ ≤ t. the gamble in (6) is exactly the right framework for thinking about asset prices. cτ . θ) Proof: See Appendix. (6) where εt+1 is a random variable with mean zero and unit variance that represents the gamble. below. for infitesimal dμ and dσ that make the household just indifferent between (6) and (7). to which we will return in Section 2. 6 5 (9) .6. The household’s coefficient of absolute risk aversion with respect to the gamble described in (6) is given by: − Et V11 (a∗ . We defer discussion of relative risk aversion until the next subsection because defining total household wealth is complicated by the presence of human capital—that is.6 one-shot gamble in period t of the form: at+1 = (1 + rt )at + wt lt + dt − ct + σεt+1 . both of which are exogenous to the household at time t. Second. the gamble is dated t + 1 to clarify that its outcome is not in the household’s information set at time t. (6) is clearly equivalent to a gamble over net transfers dt or asset returns rt . and ct is a choice variable under control of the household at time t. (7) The quantity 2dμ/dσ 2 . ∗ . thinking of the gamble as being over rt helps clarify the connection between (6) and asset prices. θ) . (8) simplifies to: −V11 (a. Following Arrow (1964) and Pratt (1965). Evaluated at the steady state. However.5 A few words about (6) are in order: First. As shown there. θt+1 ) t+1 . neither at nor ct can be the subject of the gamble: at is a state variable known with certainty at t. we can ask what one-time fee μ the household would be willing to pay in period t to avoid the gamble in (6): at+1 = (1 + rt )at + wt lt + dt − ct − μ.6 Proposition 1. Indeed. the household’s labor income. and independent of the household’s variables aτ . The gamble εt+1 is assumed to be independent of the exogenous state variables θτ for all times τ .

when they are evaluated at the nonstochastic steady state. For example. lt ). In (10). which has no clear relationship to (8)–(9) except in the one-good one-period case. θt ) = (1 + rt ) ∗ u11 (c∗ .7 Deriving the coefficient of absolute risk aversion in Proposition 1 is simple enough. lt ). lt ) . lt ) t ∗ ∂c∗ t ∗ ∗ ∂lt + u12 (ct . of course. notably −u11 (c∗ . lt )/ t ∗ u1 (c∗ . Thus. t ∗ We solve for ∂lt /∂at by differentiating the household’s intratemporal optimality con- dition: ∗ ∗ −u2 (c∗ . lt ). c and l. We compute V11 by noting that (10) holds for general at . t Boldrin. This difficulty may help to explain ∗ the popularity of “shortcut” approaches to measuring risk aversion. t (10) states that the marginal value of a dollar of assets equals the marginal utility of consumption times 1 + rt (the interest rate appears here because beginning-of-period assets in the model generate income in period t). we can compute V1 at the nonstochastic steady state by evaluating (10) at that point. even for the simplest DSGE models. t t 7 (12) Arrow (1964) and Pratt (1965) occasionally refer to utility as being defined over “money”. . rather than the curvature of the utility kernel u with respect to consumption. so one could argue that they always intended for risk aversion to be measured using indirect utility or the value function. Christiano. consumption-only endowment economy models. and have obvious similarities to Arrow (1964) and Pratt (1965). θt ) = (1 + rt ) u1 (c∗ . and Fisher (1997) derive closed-form solutions for V —and hence risk aversion—for some very simple. u1 is a known function. Here.7 Equations (8)–(9) are essentially Constantinides’ (1990) definition of risk aversion. it is the curvature of the value function V with respect to assets that matters. hence we can differentiate (10) to yield: V11 (at . ∂at ∂at (11) ∗ All that remains is to find the derivatives ∂c∗ /∂at and ∂lt /∂at . the points c∗ and lt often are known— t for example. lt ) = wt u1 (c∗ . but the problem with (8)–(9) is that closed-form expressions for V (and hence V1 and V11 ) do not exist in general. This approach is a nonstarter for even the simplest DSGE models that include labor. Although closed-form solutions ∗ for the functions c∗ and l∗ are not known in general. the Benveniste-Scheinkman equation: ∗ V1 (at . We solve this problem by observing that V1 and V11 often can be computed even when closed-form solutions for V cannot be.

lt ) − u2 (c∗ . lt )u12 (c∗ . lt+1 ).10 8 9 We do not require this restriction in the analysis below. lt ) t t t t t t (14) Note that. lt+1 )) t+1 ∂at . λt = λt+1 = λ. and the expected change in consumption at each future date t + k. . . k = 1. whatever the change in the household’s consumption today. ∂c∗ /∂at should not be too difficult to compute: it is just the household’s t marginal propensity to consume today out of a change in assets. lt ) − λt u12 (ct . t+2 ∗ ∂lt+2 /∂at . ∂at ∂at ∂at (18) (19) In other words. lt ) t t t t t t = ∗ ∗ ∗ ∗ ∗ ∗ . By ∂c∗ /∂at we mean: t+1 ∂at ∂c∗ t+1 ∂c∗ da∗ t+1 t+1 ∂at+1 dat ∂c∗ t+1 ∂at+1 ∗ ∂c∗ ∂lt − t . ∂c∗ /∂at . even starting from steady state.8 It now only remains to solve for the derivative ∂c∗ /∂at . ∂at ∂at (13) where λt ≡ ∗ ∗ ∗ ∗ ∗ ∗ wt u11 (c∗ . lt ) u1 (c∗ . lt )u12 (c∗ . in a model with internal habits. . which we can deduce from the household’s Euler equation and budget constraint. if consumption and leisure in period t are normal goods. Note that this equality does not follow from the steady state assumption. it must be the same as the expected change in consumption tomorrow. giving: ∂c∗ ∂c∗ ∂c∗ t = Et t+1 = Et t+k . lt ) t ∗ ∂c∗ ∂l∗ ∂c∗ t ∗ ∂l ∗ ∗ + u12 (c∗ . . which we will consider in Section 4.8 with respect to at . ∂at ∂at ∂at ∗ ∗ ∂l∗ ∂l ∂lt = Et t+1 = Et t+k . lt )) ∂at = ∂c∗ ∗ ∗ ∗ ∗ βEt (1 + rt+1 ) (u11 (ct+1 . lt+1 ) t+1 + u12 (c∗ . lt+1 ) t+1 t t+1 t+1 ∂at ∂at ∂at ∂at (16) ∗ Substituting in for ∂lt /∂at gives: ∗ ∗ ∗ ∗ ∗ ∂ct (u11 (ct . lt ) + u12 (c∗ . For example. β = (1 + r)−1 . lt ) u1 (c∗ . etc. then λt must be positive. lt ) t = βEt (1 + rt+1 ) u11 (c∗ . and rearranging terms to yield: ∗ ∂c∗ ∂lt = −λt t . lt ) − u2 (c∗ . Differentiating the Euler equation: ∗ ∗ u1 (c∗ . lt ) = βEt (1 + rt+1 ) u1 (c∗ . lt+1 ) − λt+1 u12 (ct+1 . t Intuitively. . the individual household’s optimal consumption response to a change in assets increases with time. 2. . lt )u11 (c∗ . . u22 (c∗ . k = 1. lt ) + wt u12 (c∗ . t t+1 (15) with respect to at yields:9 ∗ u11 (c∗ . (17) Evaluating (17) at steady state. 2. and the uij cancel. ∂at ∂at = = 1 + rt+1 + wt and analogously for 10 ∗ ∂lt+1 /∂at . but intuitively we will think of λ > 0. lt )u22 (c∗ .

We can now compute the household’s coefficient of absolute risk aversion. the household raises consumption in every period by the extra asset income. ∂at 1 + wλ (21) In response to a unit increase in assets. θ) = . r ∂at r ∂at (20) That is. Proposition 2 has the following corollary: Corollary 3. (13)–(14). which translates . satisfies: −u11 + λu12 r −V11 (a. The household’s coefficient of absolute risk aversion in Proposition 1. is given by: −V11 (a. l). the household’s coefficient of absolute risk aversion in (23) is just the traditional measure. and (21) into (9). V1 (a. First. When there is no labor margin in the model. Differentiating (2) with respect to at . (18). r. and (19) gives: ∗ 1 + r ∂c∗ 1 + r ∂lt t w = (1 + r) + . and u12 denote the corresponding partial derivatives of u evaluated at the steady state (c. −u11 /u1 . times r. Proposition 2 and Corollary 3 are remarkable. adjusted downward by the amount 1 + wλ that takes into account the household’s decrease in hours worked. θ) −u11 = r. we have proved: Proposition 2. u11 . Suppose that lt is fixed exogenously at l ≥ 0 for all t and the household chooses ct optimally at each t given this constraint. θ) u1 (23) Proof: The assumptions and steps leading up to Proposition 2. evaluated at steady state. we can solve for ∂c∗ /∂at evaluated at the steady state: t r ∂c∗ t = . evaluating at steady state. Then the household’s coefficient of absolute risk aversion (22). Substituting (10). θ) u1 1 + wλ (22) where u1 . are essentially the same as the above with λt = 0. and λ is given by (14) evaluated at steady state. adjusted to the onedimensional case. the expected present value of changes in household consumption must equal the change in assets (times 1 + r) plus the expected present value of changes in labor income. evaluated at steady state.9 The household’s budget constraint is implied by asset accumulation equation (2) and transversality condition (3). Combining (20) with (13). V1 (a. (11). and applying (3).

u12 . l)-space along which u is flat. the household can still be risk neutral: Corollary 4. households can partially absorb shocks to income through changes in hours worked. whether or not we can solve for V . l) = u(c − l) to second order for some function u. risk aversion depends on the concavity of u in all dimensions rather than just in one dimension. the traditional.e. resulting in risk-neutral behavior. ˜ In other words. If the household faces a one-shot gamble of size At in . even when consumption and labor are additively separable in u (i. Even when u11 is very large. Even in the additively separable case.5. The household’s coefficient of absolute risk aversion (22) vanishes as the discriminant u11 u22 − u2 vanishes. We provide some more concrete examples of risk aversion calculations in Section 2. regardless of whether u or the rest of the model is homothetic. risk aversion in Proposition 2 is further attenuated or amplified by the direct interaction between consumption and labor in utility. The corollary rules out that case by assumption. the special case u(c. |u22 |} 12 in the limit. Proposition 2 shows that risk aversion is less than the traditional measure by the factor 1 + wλ. Proof: The corollary is stated as a limiting result to respect concavity in Assumption 1. Substituting out λ and w. As a result. In other words. For example. static measure of risk aversion is also the correct measure in the dynamic context. u12 = 0). if there exists any direction in (c. after first defining relative risk aversion.10 assets into current-period consumption. Geometrically. When u12 = 0. when households have a labor margin. (22) vanishes as u11 u22 − u2 vanishes except for the special case 12 ˜ u1 = −u2 and u11 = −u12 = u22 —that is. the household still can be risk neutral if u22 is small or the cross-effect u12 is sufficiently large. c∗ depends on household labor supply. The household’s labor margin can have dramatic effects on risk aversion. below. the household will optimally choose to absorb shocks to income along that line. no matter how large the traditional measure −u11 /u1 . and no matter what the functional forms of u and V . for any utility kernel u.4 The Coefficient of Relative Risk Aversion The difference between absolute and relative risk aversion is the size of the hypothetical gamble faced by the household. so long as either u1 = −u2 or u12 < max{|u11 |. 2. More generally. so labor and consumption are indirectly t connected through the budget constraint.

when the household’s time endowment is not well-defined—as when u(ct . total household wealth At equals the present discounted value of leisure wt (¯− lt ) plus consumption c∗ . 2dμ/dσ 2 . then it follows from Proposition 1 that the household’s coefficient of risk aversion. so we consequently define two measures of household wealth At and two coefficients of relative risk aversion (25). τ t The factor (1 + rt )−1 in the definition expresses wealth At in beginning.11 period t. lτ )/u1 (c∗ . In these models. θ) = . Et V1 (a∗ . Equivalently. when the household’s time endowment ¯ is well specified. that is: at+1 = (1 + rt )at + wt lt + dt − ct + At σεt+1 . and where mt. we can define l human capital to be the present discounted value of the household’s time endowment. θt+1 ) t+1 (25) The natural definition of At . there are two natural definitions of human capital. is the household’s wealth at time t. with At ≡ (1 + rt )−1 Et τ =t mt. We state this formally as: Definition 1. θ) u1 1 + wλ (26) Alternatively.τ c∗ . for this gamble is given by: − At Et V11 (a∗ . considered by Arrow (1964) and Pratt (1965).rather than endof-period-t units.τ denotes the stochastic discount factor β τ −t u1 (c∗ . the present discounted value of household τ ∗ ∗ consumption. household wealth can be more difficult to define because of the presence of human capital. wt lt . (24) or the household can pay a one-time fee At μ in period t to avoid this gamble. The household’s consumption-based coefficient of relative risk aversion is ∞ given by (25). θt+1 ) t+1 . lt ) = 1+χ c1−γ /(1 −γ) −lt and no upper bound on lt is specified—it is most natural to define human t ∗ capital as the present discounted value of labor income. which follows from the budget constraint (2)–(3). however. wt ¯ In l. V1 (a. lt ). We thus have: t . First. from (2)–(3). ˜ l ∗ thise case. The gamble in (24) is then over a fraction of the household’s wealth and (25) is referred to as the household’s coefficient of relative risk aversion. total household wealth At equals the present discounted value of consumption. In DSGE models. so that in steady state A = c/r and the consumption-based coefficient of relative risk aversion is given by: −u11 + λu12 c −A V11 (a.

corresponding to alternative definitions of wealth and the size of the gamble At . A = c + w(¯ − l) /r. in steady state the household consumes exactly the flow of income from its wealth.12 Definition 2. The household’s intertemporal elasticity of substitution. which equals −u1 / c(u11 − λu12 ) by a calculation along the lines t ∗ ∗ of (17). Third. when λ = 0. V1 (a. both measures of risk aversion reduce to the traditional −c u11 /u1 when there is no labor margin in the model—that is.5 Examples Some simple examples illustrate how ignoring the household’s labor margin can lead to wildly inaccurate measures of the household’s true attitudes toward risk. (c + w(¯ − l))/c. l Other definitions of relative risk aversion. is given by dc∗ − t+1 dc∗ /d log(1 + rt+1 ).τ c∗ + wτ (¯ − lτ ) . l Proof: Note that the case w = 0 is ruled out by Assumptions 1–2. l τ ˜ In steady state. Evaluated at steady state: i) the consumption-based coefficient of relative risk aversion and intertemporal elasticity of substitution are reciprocal if and only if λ = 0. Second. First. (26) and (27) are related by the ratio of the two gambles. holding wt fixed but allowing lt and lt+1 to vary endogenously. We close this section by noting that neither measure of relative risk aversion is reciprocal to the intertemporal elasticity of substitution: Corollary 5. (27) 2. θ) u1 1 + wλ Of course. are also possible. ii) the leisure-and-consumption-based coefficient of relative risk aversion and intertemporal elasticity of substitution are reciprocal if and only if λ = (¯ − l)/c. . The household’s leisure-and-consumption-based coefficient of relative risk ∞ ∗ ˜ aversion is given by (25). evaluated at steady state. The corollary follows from comparing this expression to (26) and (27). rA. θ) −u11 + λu12 c + w(¯ − l) l = . consistent with standard permanent income theory (where one must include the value of leisure w(¯− l) as part of consumption when the value l of leisure is included in wealth). and the leisure-and-consumption-based coefficient of l relative risk aversion is given by: ˜ −A V11 (a. with At = At ≡ (1 + rt )−1 Et τ =t mt. both definitions reduce to the usual present discounted value of income or consumption when there is no human capital in the model. but Definitions 1–2 are the most natural for several reasons.

for several different values of χ. the bias explodes and true risk aversion approaches zero—the household becomes risk neutral. χ0 > 0. the bias from using the traditional measure is small because the household chooses to absorb income shocks almost entirely along its consumption margin. Intuitively. but the household’s consumption-based coefficient of relative risk aversion is given by (26): 1 −cu11 γ −AV11 = .11 so (29) can be written as: −AV11 1 . The traditional measure of risk aversion for this utility kernel is −c u11 /u1 = γ. reflecting that the household absorbs income In steady state. As a result. then the bias from using the traditional measure is small because household labor supply is essentially fixed. so c = wl holds exactly if there is neither capital nor transfers in the model. and households with linear disutility of work are clearly risk neutral with respect to gambles over hours. In any case. if γ is very small. large or small just by varying the household’s time endowment ¯ so we focus only on the consumption-based measure (29). c = ra + wl + d. ≈ 1+ 1 V1 γ χ (30) Note that (30) is less than the traditional measure of risk aversion by a factor of 1 + γ/χ. If χ is very large. ra + d is typically small for standard calibrations in the literature. the labor margin is again almost inoperative. Expression (30) also helps to clarify several points.13 Example 2.12 However. if γ = 2 and χ = 1—parameter values that are well within the range of estimates in the literature—then the household’s true risk aversion is less than the traditional measure by a factor of about three. 11 12 Similarly. 1−γ 1+χ (28) where γ. . a common benchmark in the literature. Consider the additively separable utility kernel: u(ct . This point is illustrated in Figure 1.1. wu11 = γ V1 u1 1 + w u22 1 + χ wl c (29) The household’s leisure-and-consumption-based coefficient of relative risk aversion (27) is not well defined in this example (the household’s risk aversion can be made arbitrarily l). lt ) = l1+χ c1−γ t − χ0 t . Thus. households with linear disutility of work are risk neutral with respect to gambles over wealth because they can completely offset those gambles at the margin by working more or fewer hours. First. In steady state. χ. risk aversion in the model is a combination of both parameters γ and χ. as χ approaches 0. which graphs the coefficient of relative risk aversion for this example as a function of the traditional measure. γ. c ≈ wl.

Second. u(ct . ¯ = 1. χ > 0. lt ) = 1+χ c1−γ /(1− γ) − χ0lt /(1+ χ) in Example 2.1. having an additional margin with which to absorb income gambles reduces the household’s aversion to risk. Third. for any given γ.2. Consumption-based coefficient of relative risk aversion for the utility kernel u(ct . Put another way. for different t values of χ. gambles along both of its margins. The traditional l measure of risk aversion for (31) is γ. Consider the King-Plosser-Rebelo-type (1988) utility kernel: c1−γ (1 − lt )χ(1−γ) . reflecting that labor and consumption enter symmetrically into u in this example and play an essentially equal role in absorbing income shocks. (30) is symmetric in γ and χ. ignoring the labor margin in this example would be just as erroneous as ignoring the consumption margin.14 10 9 8 = Ccoeffic cient of relative risk aversion 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 =5 =4 =3 =2 =1 =0 10 Figure 1. lt ) = t 1−γ (31) where γ > 0. That is. as a function of the traditional measure γ. depending on χ. See text for details. actual risk aversion in the model can lie anywhere between 0 and γ. γ = 1. Example 2. but the household’s actual leisure-and-consumption- . and χ(1 − γ) < γ for concavity. consumption and labor.

1 Measuring Risk Aversion with V As Opposed to u Some comparison of the expressions −V11 /V1 and −u11 /u1 helps to clarify why the former measure is the relevant one for pricing assets. such as stocks or bonds. In this example. Clearly.15 based coefficient of relative risk aversion is given by: ˜ −u11 + λu12 c + w(1 − l) −A V11 = = γ − χ(1 − γ). As in the previous example. except for the special case χ = 0. in the model. In order for −u11 /u1 to be the relevant measure for pricing a security. as utility approaches Cobb-Douglas— the household becomes risk neutral. −V11 /V1 is the Arrow-Pratt coefficient of absolute risk aversion for gambles over income or wealth in period t. such as a stock or bond. it is the former concept that corresponds to the stochastic payoffs of a standard asset. (33) is a combination of the parameters γ and χ. we showed that the labor margin has important implications for Arrow-Pratt risk aversion with respect to gambles over income or wealth. (32) depends on both γ and χ. so the household finds it optimal to absorb shocks to wealth along that line. From Proposition 1. in a DSGE model. We now show that risk aversion with respect to these gambles is also the right concept for asset pricing.6 Risk Aversion and Asset Pricing In the preceding sections. the expression −u11 /u1 is the risk aversion coefficient for a hypothetical gamble in which the household is forced to consume immediately the outcome of the gamble. Neither (32) nor (33) equals the traditional measure γ. risk aversion is less than the traditional measure by the amount χ(1 − γ). In contrast. depending on χ. depending on χ. 2. household utility along the line ct = wt (1−lt ) is linear. 2. V1 u1 1 + wλ (32) Note that concavity of (31) implies that (32) is positive. in this case. and can lie anywhere between 0 and γ. and can lie anywhere between 0 and the traditional measure γ. V1 u1 1 + wλ 1+χ (33) Again. The household’s consumption-based coefficient of relative risk aversion is a bit more complicated than (32): −A V11 c −u11 + λu12 γ − χ(1 − γ) = = .6. it is not enough that the security pay off in . As χ approaches γ/(1 − γ)—that is.

16 units of consumption in period t + 1. and hence the labor margin. and Risk Premia Arrow-Pratt risk aversion. It is difficult to imagine such a security in the real world—all standard securities in financial markets correspond to gambles over income or wealth. The percentage difference between the risk-neutral price of the asset and its actual price—the risk premium on the asset—is given by: Et mt+1 Et pt+1 − Et mt+1 pt+1 /Et mt+1 = −Covt (dmt+1 . lt+1 )/u1 (c∗ . dpt+1 )/Et mt+1 (34) where Covt denotes the covariance conditional on information at time t. For example.2 Risk Aversion. lt+1 )dc∗ + u12 (c∗ . lt ) t (35) conditional on information at time t. t+1 t+1 t+1 ∗ u1 (c∗ . if u12 = 0. 2. and d) may change as well as a. we have. changes in lt+1 directly affect the household’s marginal utility of consumption. r. For small changes dc∗ and dlt+1 . lt ) denote the household’s stochastic discount factor t+1 t and let pt denote the cum-dividend price of a risky asset at time t. to first order: t+1 dmt+1 = β ∗ ∗ ∗ u11 (c∗ . for which the −V11 /V1 measure of risk aversion is the appropriate one. p}. differentiating (12) and evaluating at steady state. then dmt+1 equals the t+1 t+1 coefficient of absolute risk aversion times dat+1 . one can already see the relationship between risk aversion and dmt+1 in (35): ∗ if dlt+1 = −λdc∗ and dc∗ = rdat+1 /(1 + wλ). In (35). is also closely tied to asset prices in the standard Lucas-Breeden stochastic discounting framework. the relationship is slightly more complicated than this because θ (and hence w. In actuality. lt+1 )dlt+1 . and dx ≡ xt+1 − ∗ Et xt+1 . t+1 Intuitively.6. ∗ ∗ Let mt+1 = βu1 (c∗ . as in Section 2. The household would additionally have to be prevented from adjusting its consumption and labor choices in period t + 1 in response to the security’s payoffs. the household’s labor margin affects mt+1 and hence asset prices for two reasons: First. with Et pt+1 normalized to unity. the Stochastic Discount Factor. u22 + wu12 (36) . the presence of the labor margin affects how the household responds to shocks and hence affects dc∗ . Second. to first order: ∗ dlt+1 = −λdc∗ − t+1 u1 dwt+1 .3. even if u12 = 0. we have. so that the household is forced to absorb those payoffs into period t+1 consumption. x ∈ {m.

t+k . is then given by: r −u11 + λu12 Covt (dpt+1 . and thus the first line of (37) describes the income effect on consumption. dAt+1 ) + r Covt (dpt+1 . combining (2). The last line of (37) describes the substitution effect: changes in consumption due to changes in current and future interest rates and wages. 1 + wλ The risk premium (34). an asset that pays off well when future interest rates are high or wages are low—and hence future consumption is low—is preferable to an asset that has no correlation with future r or w. r. evaluated at steady state. while the second term captures the asset’s ability to hedge what Merton calls “changes in investment opportunities. In (39).” Intuitively. and d were all held constant. the aggregate variables w. we show in the Appendix that: dc∗ t+1 r = dat+1 + Et+1 1 + wλ ∞ k=1 1 (l dwt+k + ddt+k + adrt+k ) (1 + r)k ∞ (37) 1 u1 −ru1 + dwt+1 + Et+1 2 u11 − λu12 (1 + r)k u11 u22 − u12 k=1 where Rt+1. The term in square brackets in (37) describes the change in the present value of household income.t+k ≡ k i=2 (1 + rt+i ). generalized to include labor. u1 1 + wλ (39) where dAt+1 denotes the quantity in square brackets in (38)—the change in household wealth—and dΨt+1 denotes the summation on the second line of (38)—the change in current and future wages and interest rates. (3).) Substituting (36)–(37) into (35) yields: dmt+1 u11 − λu12 r = β dat+1 + Et+1 u1 1 + wλ ∞ ∞ k=1 1 (l dwt+k + ddt+k + adrt+k ) (1 + r)k (38) − βr Et+1 k=1 1 (1 + r)k λ dwt+k − d log Rt+1. and evaluating at steady state. Equation (39) shows the importance of risk aversion—and hence the labor margin—for asset pricing in the model.t+k .17 Similarly. even for households that are Arrow-Pratt risk neutral. λ dwt+k − d log Rt+1. (Recall that −u1 / c(u11 − λu12 ) is the intertemporal elasticity of substitution. and (15). 1 + wλ Note that for the Arrow-Pratt one-shot gamble considered in Section 2. multiplied by the coefficient of absolute risk aversion. differentiating.3. dΨt+1 ). Risk premia are essentially linear in the coefficient of absolute risk . Equations (38)–(39) are essentially Merton’s (1973) ICAPM. the first term is the covariance of the asset price with household wealth. so (36)–(37) reduce to (13) and (21) in that case.

For an example of this linearity. α = 1. θt+1 )1−α ct . θt ) = max cρ + β Et V (at+1 . As shown above. . Christiano. (41) See the Appendix. 3. Epstein-Zin preferences over consumption streams have been written as: V (at . (40) where α ∈ R. a relationship which also holds for the more general cases of Epstein-Zin preferences and habits.1 in Epstein and Zin (1989) shows that there exists a solution V to (40) with V ≥ 0. What explains Boldrin et al.lt 1/(1−α) . The household’s asset accumulation equation (2) and transversality condition (3) are the same as in Section 2. θt+1 ))1−α ct . Boldrin. but the stochastic discount factor is itself directly linked to risk aversion and the household’s labor margin. the household chooses ct and lt to maximize the recursive expression:15 V (at . considered below. and net transfers. 15 Note that. see Figure 1 of Rudebusch and Swanson (2009). then the proof of Theorem 3. wages. θt ) = max u(ct . this can be seen to correspond to (40). Here we have shown that the same coefficient also appears for completely general gambles that may be correlated with aggregate variables such as interest rates. the preferences given by (40) reduce to the special case of expected utility. and Fisher (1997) argue that it is u11 /u1 rather than V11 /V1 that matters for the equity premium in their Figure 2. θt+1 )α t ct ρ/α 1/ρ . If u ≤ 0 everywhere. θt ) = max u(ct . Generalized Recursive Preferences We now turn to the case of generalized recursive preferences. traditionally. lt ) + β Et V (at+1 .’s Figure 2 is that the covariance of equity prices with the short-term interest rate is not being held constant in their model—in particular. as in Epstein and Zin (1989) and Weil (1989). but now instead of maximizing (1). then it is natural to let V ≤ 0 and reformulate the recursion as: V (at . but with the value function “twisted” and “untwisted” by the coefficient 1 − α.18 aversion. lt ) − β Et (−V (at+1 .lt 13 14 1/(1−α) . When α = 0. If u ≥ 0 everywhere.16 Note that (40) is the same as (4).13 This link between risk aversion and risk premia should not be too surprising: Arrow-Pratt risk aversion describes the risk premium for the most basic gambles over household income or wealth. but by setting V = V ρ and α = 1 − α/ρ. 16 We exclude the case α = 1 here for simplicity.14 The risk premia on these gambles are determined by the household’s stochastic discount factor. it is in fact V11 /V1 that is crucial. the variance of the risk-free rate in their model changes tremendously over the points in their Figure 2.

When α = 0. The first term in (43) is the same as the expected utility case (9). When u ≥ 0 and hence V ≥ 0. l 17 (43) . or u : R+ × [0. θt+1 )−α V11 (a∗ . To avoid the possibility of complex numbers arising in the maximand of (40) or (41). θ) V (a. θ) Proof: See Appendix. θ) −V11 (a. when u and V ≤ 0. while the second term in (43) reflects the amplification or attenuation of risk aversion from the additional curvature parameter α..g. higher values of α correspond to greater degrees of risk aversion. 3. V1 (a. e. With generalized recursive preferences (40) or (41). by requiring c ≥ 1 for u(c. the intertemporal elasticity of substitution over deterministic consumption paths is exactly the same as in (4). l) = log c + χ(¯ − l). the household’s coefficient of absolute risk aversion with respect to the gamble described by (6) is given by: −Et V (a∗ . θt+1 )2 t+1 V (a∗ . (42)–(43) reduce to (8)–(9). θt+1 ) t+1 . ¯ → R− . (42) simplifies to: V1 (a. θt+1 ) − α t+1 t+1 V1 (a∗ .1 Coefficients of Absolute and Relative Risk Aversion We consider the household’s aversion to the same hypothetical gamble as in (6): Proposition 6. ∗ . l) l) The main advantage of generalized recursive preferences (40) is that they allow for greater flexibility in modeling risk aversion and the intertemporal elasticity of substitution. In (40).θ −α V (a∗ . θ Et V (at+1 t+1 ) 1 t+1 t+1 ) (42) Evaluated at steady state.19 The proof in Epstein and Zin (1989) also demonstrates the existence of a solution V to (41) with V ≤ 0 in this case. one can restrict the domain of u to ensure u ≥ 0 or u ≤ 0. Alternatively. the opposite is true: higher values of α correspond to lesser degrees of risk aversion. ¯ → R+ . θ) +α . Either u : R+ × [0. but the household’s risk aversion to gambles can be amplified (or attenuated) by the additional parameter α. we restrict the range of u to be either R+ or R− :17 Assumption 6.

lt ) (Et V (a∗ . l 18 Note that. is given by (c + w(¯ − l))/c times (46).18 Expressions (43) and (44) highlight an important feature of risk aversion with generalized recursive preferences: it is not invariant with respect to level shifts of the utility kernel.20 The household’s coefficient of relative risk aversion is given by At times (42). +α V1 V u1 1 + wλ u (45) The household’s consumption-based coefficient of relative risk aversion. evaluated at steady state. At steady state. . expressions (10)– ∗ (21) for V1 . evaluated at steady state. The household’s preferences are invariant. and we refer to (44) as the consumption-based or leisure-and-consumption-based coeffcient of relative risk aversion. θt+1 )1−α )1/(1−α) t t+1 which must be used to compute household wealth. with respect to multiplicative transformations of the utility kernel.4. the household’s stochastic discount factor is given by: ⎞ −α ⎛ ∗ βu1 (c∗ . the utility kernels u(·. which. is given by: −AV11 −u11 + λu12 c u1 c AV1 = + α . simplifies to: AV1 (a. θ) V (a. t V = u(c. V1 (a. is given by: −V11 −u11 + λu12 r u1 r V1 = + α . ·)+k. with generalized recursive preferences. θ) +α . Moreover. and ∂c∗ /∂at continue to apply in the current context. When it comes to computing the risk aversion coefficients (43)–(44). as in Section 2. V11 . Substituting these into (43)–(44) gives: Proposition 7. this simplifies to the usual β. except for the special case of expected utility (α = 0). evaluated at steady state. depending on the definition of A. ∂lt /∂at . however. θ) −AV11 (a. ·) and u(·. lead to different household attitudes toward risk. l) (1 − β) at the steady state. where k is a constant. That is. evaluated at steady state. +α V1 V u1 1 + wλ u (46) The household’s leisure-and-consumption-based coefficient of relative risk aversion. however. ∗ u1 (c∗ . θ) (44) We define the household’s total wealth At based on the present discounted value of its lifetime consumption or lifetime leisure and consumption. The household’s coefficient of absolute risk aversion in Proposition 6. θt+1 ) t+1 t+1 ⎠ ⎝ . lt+1 ) V (a∗ .

is valid for general functional forms u. (48) decreases to α(1 − γ)/γ. Rudebusch and Swanson (2009) refer to γ + α(1 − γ) as the quasi coefficient of relative risk aversion. ·) < 0.19 In this case. consumption-only models. ·) < 0. so we restrict attention to the consumption-based measure (48). and γ > 1. 19 . and Fisher (1997). In models without labor. the household’s consumption-based coefficient of relative risk aversion (46) is given by: γ −AV11 AV1 α(1 − γ) = +α . In models with variable labor. 20 Set χ0 = 0 and λ = 0 and substitute (47) into (46). As χ approaches zero. where the value function can be computed in closed form. risk aversion is decreasing in α. which do not have labor. which we will refer to as the traditional measure. Christiano. in Epstein and Zin (1989) and Boldrin. Of course. 3.21 Proposition 7 is important because risk aversion for Epstein-Zin preferences has only been computed previously in homothetic. The case γ ≤ 1 can be considered if we place restrictions on the domain of ct and lt such that u(·. As in Example 2. Consider the additively separable utility kernel: u(ct . which was used by Rudebusch and Swanson (2009). the household’s leisure-and-consumption-based coefficient of relative risk aversion is not well defined in this example. for example. We restrict attention here to the case γ > 1. χ0 > 0. isoelastic. period utility u(ct . which is close to zero if we think of γ as being small (close to unity). 1−γ 1+χ (47) with generalized recursive preferences (41) and χ > 0. unknown functional forms V . consistent with Assumption 6. ·) > 0. lt ) = c1−γ /(1 − γ) implies a coefficient t of relative risk aversion of γ + α(1 − γ). As χ becomes large.1.20 Taking into account both the consumption and labor margins of (47). 1 + 1+χ (48) using c ≈ wl. one can always choose units for ct and lt such that this doesn’t represent much of a constraint in practice. γ wl + γ−1 V1 V 1+ χ c 1 + 1+χ wl c ≈ γ 1+ γ χ + α(1 − γ) γ−1 . one can also consider alternative utility kernels with γ ≤ 1 for which u(·.2 Examples Example 3. where u(·.1. and allows for the presence of labor. This is the case. lt ) = l1+χ c1−γ t − χ0 t . Proposition 7 does not require homotheticity. household labor becomes less flexible and the bias from ignoring the labor margin shrinks to zero ((48) approaches γ + α(1 − γ)). and α < 0 corresponds to preferences that are more risk averse than expected utility.

1). (52) t+1 (1 − β)(1 − χ) 1+θ l u(ct . after mapping each study’s notation over to the present paper’s. lt ) = t 1−γ 1−γ . call γ + α(1 − γ) the coefficient of relative risk aversion. (53) with utility kernel: We can compute the coefficient of absolute risk aversion for (52) by following along the steps in the proof of Proposition 6. so consumption becomes trivial to insure with variations in labor supply. Tallarini (2000) considers an alternative Epstein-Zin specification: ∗ ˜ Vt (at .22 Thus. lt ) = log ct + θ log(¯ − lt ).21 Example 3. which yields: (1 − β)(1 − χ) −V11 (a. +α V1 V ˜ ˜ AV1 −AV11 = γ + α(1 − γ). w/c → ∞. +α V1 V (50) while the leisure-and-consumption-based coefficient of relative risk aversion is: (51) The latter agrees with the Van Binsbergen et al. (2008) and Backus. γ = 1. Van Binsbergen et al. depending on the value of χ. Example 3. θt+1 ) . Substituting (49) into (46). θt ) ≡ u(c∗ . we have provided the formal justification for both measures. actual household risk aversion can lie anywhere between about zero and γ + α(1 − γ).2. use γν + α(1 − γ)ν + (1 − ν). (2008) measure of risk aversion. The former measure effectively treats consumption and leisure as a single composite commodity. In this paper. Van Binsbergen et al. V1 (a. and ν ∈ (0. This explains why the consumption-based coefficient of relative risk aversion in (50) vanishes as ν → 0. (50) and (51). θ). lt ) + t β(1 + θ) (1 − β)(1 − χ) ˜ log Et exp Vt+1 (a∗ . for given values of γ and α. (2008) measure. . while the former is similar to (though not quite the same as) the Backus et al. Routledge. while the latter measure allows ν— the importance of the labor margin—to affect the household’s attitudes toward risk. while Backus et al.3. θ) − V1 (a. (49) where γ > 0. and Zin (2008) consider generalized recursive preferences with: cν (1 − lt )1−ν u(ct . the household’s consumption-based coefficient of relative risk aversion is: AV1 −AV11 = γν + α(1 − γ)ν. θ) 1+θ 21 (54) As ν → 0.

For any feasible state. lt ). As θ/χ approaches zero. or habits. but from consumption relative to some reference level. ∞) × [0. if we normalize c to 1 in (55). the household’s optimal choice (c∗ . can have substantial effects on the household’s attitudes toward risk (e. ¯ ¯ ct > ht − h. so substituting in for V1 and V11 in (54) yields a consumption-based coefficient of relative risk aversion of: 1−χ 1−χ c −u11 + λu12 1 − cu1 = − . and Fisher. ¯ → R− . 1997). u1 1 + wλ 1+θ 1 + θc 1+θ (55) The leisure-and-consumption-based coefficient of relative risk aversion is (1 + θ) times (55).. ¯ h ≥ 0. −cu11 u1 − 1−χ 1+θ cu1 . ¯ ¯ Assumption 6 . The rest of Assumption 1 applies. As a result. Habits.g. In this section. l). We generalize the household’s utility kernel in this section to u(ct − ht . or habit stock. Both coefficients of relative risk aversion differ from the value (θ + χ)/(1 + θ) reported by Tallarini (2000). We focus on an additive rather than multiplicative specification for habits because the implications for risk aversion are typically more interesting in the additive case. 1999. derived in a consumption-only model under the assumption θ = 0. Internal and External Habits Many studies in macroeconomics and finance assume that households derive utility not from consumption itself. However. l) l) . in turn. ∞) × [0. 2. Tallarini applies the traditional measure of risk aversion. simply setting θ > 0 in the traditional measure. ∗ Assumption 2 . 4. where ht denotes the household’s reference level of consumption. Christiano. or u : (−h. ∞) × [0. ¯ l). For every t. the labor margin becomes unimportant and this bias disappears. but the bias can be arbitrarily large as the ratio of θ to χ increases. Tallarini’s traditional measure overstates the household’s true aversion to risk by a factor of 1 + θ/χ. The function u is defined over (−h. we investigate how habits affect risk aversion in the DSGE framework. Campbell and Cochrane. We adjust the feasible choice set for ct and Assumptions 1. ¯ → R+ .23 The other steps leading up to Proposition 7 are all the same. to the case where θ > 0. Boldrin. and 6 accordingly. ∞) × [0. lt ) lies in the t ¯ interior of (−h. replacing them with: ¯ Assumption 1 . Either u : (−h. ignores the fact that households vary their labor in response to shocks.

1 External Habits When the reference consumption level ht in the utility kernel u(ct − ht . . the coefficient of absolute risk aversion continues to be given by (9) in the case of expected utility and (43) in the case of generalized recursive preferences. Consider the case of expected utility with additively separable utility kernel: 1+χ lt (ct − ht )1−γ u(ct − ht . . . k = 1. Example 4. then the parameters that govern the process for ht can be incorporated into the exogenous state vector θt . l) rather than (c. first. (56)–(58) imply: (59) The only real differences that arise relative to the case without habits is. ·). Together with the budget constraint (2)–(3). and the household’s Euler equation (15) still implies: ∂c∗ ∂c∗ ∂c∗ t+1 t = Et = Et t+k . l). 2. . that relative risk aversion confronts the household with a hypothetical gamble over c rather than c − h. and second.1. We consider each of these cases in turn. ·) are evaluated is (c − h.24 If the habit stock ht is external to the household (“keeping up with the Joneses” utility). (57) (58) evaluated at steady state. lt ) is external to the household. . because the stakes are effectively larger. that the steady-state point at which the derivatives of u(·. ∂at ∂at ∂at r ∂c∗ t . 2. . ∂at ∂at (56) where λt is given by (14). if the habit stock ht is a function of the household’s own past levels of consumption. and the analysis proceeds much as in the previous sections. In particular. The household’s intratemporal optimality condition (12) still implies: ∗ ∂c∗ ∂lt = −λt t . then the parameters that govern ht can be incorporated into the exogenous state vector θt and the analysis of the previous sections carries over essentially as before. which has a tendency to make the household more risk averse for a given functional form u(·. then the state variables of the household’s optimization problem must be augmented to include the state variables that govern ht . However. lt ) = − χ0 . 4. = ∂at 1 + wλ k = 1. ∂at ∂at ∂at ∗ ∗ ∂l∗ ∂l ∂lt = Et t+1 = Et t+k . 1−γ 1+χ (60) .

When there is a labor margin. In the Appendix. the consumption-based measure agrees with the traditional measure. we must specify how the household’s actions affect its future habits. (62) Again. (64) . Ignoring the labor margin in (61) thus leads to an even greater bias in the model with habits (h > 0) than in the model without habits (h = 0). If γ = 2.8c. When the household has generalized recursive preferences rather than expected utility preferences. the bias from ignoring the labor margin in (62) is even greater in the model with habits (h > 0) than without habits (h = 0). χ0 > 0. χ(c−h) using wl ≈ c. in the present section we focus on the case where habits are proportional to last period’s consumption: ht = bct−1 .2 Internal Habits When habits are internal to the household. 4. and h = . = γc (c − h) 1 + χ(c−h) wl c (61) When there is no labor margin in the model (λ = 0). then the household’s true risk aversion is smaller than the traditional measure by a factor of more than ten. The consumption-based coefficient of relative risk aversion is: 1 −AV11 −cu11 = . we derive the corresopnding closed-form expressions for the more complicated case where the habit stock evolves according to the longer-memory process: ht = ρht−1 + bct−1 . (63) b ∈ (0. χ = 1. 1). which exceeds γ by a factor that depends on the importance of habits relative to consumption. and we assume the household has expected utility preferences. the consumption-based coefficient of relative risk aversion for (60) is: γc (c − h) 1 + 1 γc wl χ(c−h) c + α(1 − γ)c (c − h) 1 + 1 γ−1 wl c (c−h) 1+χ c . In order to minimize notation and emphasize intuition.25 where γ. V1 u1 1 + w wu11 u22 1 γc . the household’s consumptionbased coefficient of relative risk aversion (61) is less than the traditional measure by the factor 1 + γc . χ. The traditional measure of risk aversion for this example is −cu11 /u1 = γc/(c − h).

θt+1 )2 t+1 t+1 V (a∗ . h∗ . θt+1 )−α V11 (a∗ . lt ) = βEt V1 (a∗ . h∗ . θt ) and lt ≡ l∗ (at .26 with ρ ∈ (−1. lt ). h∗ . a∗ ≡ (1 + rt )at + wt lt + dt − c∗ and h∗ ≡ bc∗ . ht . (65) ∗ where c∗ ≡ c∗ (at . ∗ . θt+1 ). we derive the corresponding closed-form expressions for the more complicated case of generalized recursive preferences. θt ) = u(c∗ − ht . t t+1 t+1 (66) Evaluated at steady state. lt ) = −βwt Et V1 (a∗ . t+1 t t+1 t The household’s coefficient of absolute risk aversion can be derived in the same manner as in Propositions 1 and 6: Proposition 8. lt ) + β Et V (a∗ . In order to minimize notation and simplify this derivation as much as possible. we restrict attention in the main text to the case of expected utility preferences (α = 0). t t+1 t+1 t+1 t+1 ∗ u2 (c∗ − ht . h. h∗ . θt+1 ) − α t+1 t+1 t+1 t+1 V1 (a∗ . because of the dynamic relationship between the household’s current consumption and its future habits. V1 (a. the value of ht+1 depends on the household’s choices in period t. θ −α V (a∗ . h∗ . θ) Proof: Essentially identical to the proof of Proposition 6. ht . and a∗ and t+1 h∗ denote the optimal stocks of assets and habits in period t + 1 that are implied by c∗ t t+1 ∗ ∗ and lt . ht . θ Et V (at+1 t+1 t+1 ) 1 t+1 t+1 t+1 ) −V11 (a. h∗ . θt+1 ) − βbEt V2 (a∗ . h. 1). θt+1 ). utility kernel u(ct − ht . however. θt+1 )1−α t t+1 t+1 1/(1−α) . h. With generalized recursive preferences (40) or (41). In the Appendix. and internal habits ht given by (63). The household’s first-order conditions for (65) with respect to consumption and labor (and imposing α = 0) are given by: ∗ u1 (c∗ − ht . θ) V1 (a. θ) +α . θt+1 ) t+1 t+1 . h∗ . h. that is. h∗ . θ) V (a. θt ) denote the household’s optimal choices for t consumption and labor in period t as functions of the household’s state vector. Computing closed-form expressions for V1 and V11 in (67) is substantially more complicated for the case of internal habits. h∗ . With internal habits. (66) simplifies to: (67) (68) (69) . the household’s coefficient of absolute risk aversion with respect to the gamble (6) is given by: −Et V (a∗ . h∗ . so we write out the dependence of the household’s value function on ht explicitly: ∗ V (at .

t (70) (71) Equations (69) and (70) can be used to solve for V1 in terms of current-period utility: V1 (at . we henceforth let a time subscript τ ≥ t denote a generic future date and reserve the subscript t to denote the date of the current period—the period in which the household faces the hypothetical one-shot gamble. τ τ τ τ τ τ ∗ = wτ (1 − βbF ) u1 (c∗ − h∗ . lt ). t+1 t+1 ∗ V2 (at . lτ ) = wτ u1 (c∗ − h∗ . wt ∂at ∂at (73) where we drop the arguments of the uij to reduce notation. lt ). θt+1 ). in steady state it is also true that V1 = u1 (1 − βb)/β. θt ) = −u1 (c∗ − ht . lτ ). ∗ We solve for ∂lτ /∂at in terms of ∂c∗ /∂at in much the same way as without habits. θt ) = − (1 + rt ) ∗ u2 (c∗ − ht . Differentiating (75) with respect to at yields: −u12 ∂h∗ ∂c∗ τ τ − ∂at ∂at ∗ ∂h∗ ∂c∗ ∂lτ τ τ = wτ (1 − βbF ) u11 − − u22 ∂at ∂at ∂at ∗ ∂lτ + u12 . τ τ (74) (75) where F denotes the forward operator. h∗ +1 . except that the dynamics t ∗ of internal habits require us to solve for ∂c∗ /∂at and ∂lτ /∂at for all dates τ ≥ t at the τ same time. ht . . differentiate (72) with respect to at to yield: V11 (at . t wt (72) which states that the marginal value of wealth equals the marginal utility of working fewer hours. ∂at (76) 22 Using the marginal utility of labor is simpler than the marginal utility of consumption in (72) because it avoids having to keep track of future habits and the value function next period. lτ ) + bβEτ V2 (a∗ +1 . θτ +1 ) . which we do in the same manner as before. Differentiating (65) with respect to its first two arguments and applying the envelope theorem yields: V1 (at . However. It now remains to solve for ∗ ∂c∗ /∂at and ∂lt /∂at . The first-order condition (68). ht . To solve for V11 . ht . that is F xτ ≡ Eτ xτ +1 for any expression x dated τ . ht . however. which we will use to express risk aversion in terms of u1 and u11 below. θt ) = − ∂c∗ ∂l∗ (1 + rt ) u12 t + u22 t . h∗ . τ The household’s intratemporal optimality condition ((68) combined with (69)) implies: ∗ ∗ −u2 (c∗ − h∗ . θt ) = β(1 + rt ) Et V1 (a∗ .27 Equation (69) is essentially the same as in the case without habits. To better keep track of these dynamics.22 This solves for V1 . includes the future effect of consumption on habits in the second term on the right-hand side.

Lxτ ≡ xτ −1 for any expression x dated τ —and we assume |βbwu12 /(u22 + wu12 )| < 1 in order to ensure convergence. This As before. also implies: (1 − βbF )(1 − F ) ∗ ∂lτ = 0. ∂at ∂l∗ (1 − F ) τ = 0. L denotes the lag operator—that is. we solve for ∂c∗ /∂at using the household’s Euler equation and budget conτ straint. Evaluating (76) at steady state and solving for ∂lτ /∂at yields: ∗ ∂lτ βbwu12 u12 + wu11 − βbwu11 F 1− = − F ∂at u22 + wu12 u22 + wu12 −1 (1 − bL) ∂c∗ τ . . ∂at (83) (84) 23 To be precise. ∂at ∂c∗ τ = 0. and ∂h∗ /∂at = 0 for τ = t τ τ τ τ τ ∗ since ht is given. Formally. ∂at (77) where the uij are evaluated at steady state. ∂at (80) u22 (1 − F ) u12 + wu11 − βbwu11 F (1 − bL) Since F L = 1. τ τ τ τ wτ wτ +1 with respect to at and evaluating at steady state yields: u12 (1 + b) − F − bL ∂l∗ ∂c∗ τ = −u22 (1 − F ) τ . τ ∂c∗ τ . F Lxτ = Eτ −1 xτ . ∂at as in Section 2. (77) reduces to − wu11 +u12 u22 +wu12 ∗ solves for ∂lτ /∂at in terms of (current and future) ∂c∗ /∂at . Differentiating the household’s Euler equation: 1 1 + rτ +1 ∗ ∗ u2 (c∗ − h∗ . from (79). hence we can invert the (1 − βbF ) operator forward to get: ∂c∗ (1 − F )(1 − bL) τ = 0. but since the household evaluates these expressions from the perspective of the initial period t. lτ +1 ) ∂c∗ +1 /∂at .28 ∗ where F u11 ∂c∗ /∂at denotes Eτ u11 (c∗ +1 − h∗ +1 .23 equation (80) simplifies to: (1 − βbF )(1 − F )(1 − bL) which. Note that when b = 0. ∂at (81) (82) Equations (81) and (82) hold for all τ ≥ t. take the expectation of (80) at time t and then apply Et F L = Et to get (81). Et F Lxτ = Et xτ . ∂at ∂at (79) (78) Substituting (77) into (79) yields the following difference equation for cτ : u12 u22 + wu12 − βbwu12 F (1 + b) − F − bL − ∂c∗ τ = 0. lτ +1 ). lτ ) = βEτ u2 (c∗ +1 − h∗ +1 .

an increase in assets would cause consumption to rise by the amount of the income flow from the change in assets. . we have: ∞ Et τ =t (1 + r)−(τ −t) ∗ ∂c∗ 1 + r ∂lt τ = (1 + r) + w . 24 However. ∂at ∂at ∂c∗ ∂c∗ Et t+k = (1 + b + · · · + bk ) t . ∂at r ∂at (89) Substituting (85)–(87) into (89) and solving for ∂c∗ /∂at yields: t (1 − βb)r ∂c∗ t = . . and the consumption response is further attenuated by the household’s change in hours worked. From (85). asymptoting over time to its new steady-state level. . Thus. ∂at ∂at ∗ ∗ ∂lt+k ∂lt = . but labor moves immediately to its new steady-state level in response to surprises in wealth. The presence of habits attenuates this change by the amount βb in the numerator of (90). consumption responds only gradually to a surprise change in wealth. r. It now remains to solve for ∂c∗ /∂at . ∂at 1 + (1 − βb)wλ (90) Without habits or labor. and Et ∂at ∂at (85) (86) evaluated at steady state. which is accounted for by the denominator.29 ∗ In other words. unlike the model without habits. whatever the initial responses ∂c∗ /∂at and ∂lt /∂at are. Because of habits. that (87)–(88) are essentially identical to (13)–(14). (87)–(88) only hold here in steady state. we must have: t ∂c∗ ∂c∗ Et t+1 = (1 + b) t . . ∂at ∂at (87) where λ ≡ w(1 − βb)u11 + u12 u1 u12 − u2 u11 = . 2. λ must be positive if leisure and consumption are normal goods. k = 1. From the household’s budget constraint and t condition (86). we can now solve (79) to get: ∗ ∂c∗ ∂lt = −λ t .24 Again. u22 + w(1 − βb)u12 u1 u22 − u2 u12 (88) and where the latter equality follows because w = −(1 − βb)−1 u2 /u1 in steady state.

(92) = V1 u1 1 + (1 − βb)wλ The household’s leisure-and-consumption-based coefficient of relative risk aversion. Example 4. evaluated at steady state. 1+ χ where the last line uses β ≈ 1 and wl ≈ c. In thise case. = γ γ 1−βb wl 1 − b 1 + χ 1−b c γ ≈ γ . V1 u1 1 + (1 − βb)wλ 1 − βb 1 . This is in sharp contrast to the case of external habits. but now with habits ht = bct−1 internal to the household rather than external. t t+1 t+1 1 + rt with respect to at to solve for V11 using (85)–(88) and (90). equation (61)). lt+1 ). is given by: −u11 + λu12 (1 − βb)r −V11 = . V1 u1 1 + (1 − βb)wλ (91) The household’s consumption-based coefficient of relative risk aversion. and (90) into (67). ht . In order to express (91) in terms of u1 and u11 instead of u2 and u22 . we have established:25 Proposition 9. χ. (88).2. evaluated at steady state. we use V1 = (1 − βb)u1 /β and differentiate the first-order condition: 1 ∗ ∗ u1 (c∗ − ht . evaluated at steady state. The most striking feature of equation (94) is that it is independent of b.30 Substituting (72). the household’s consumption-based coefficient of relative risk aversion is given by: −AV11 1 − βb −cu11 = . u(ct − ht . lt ) = 1−γ 1+χ (93) where γ. χ0 > 0. (87). is given by (c + w(¯ − l))/c times (92).1: 1+χ lt (ct − ht )1−γ − χ0 . is given by: (1 − βb)c −u11 + λu12 −AV11 . Consider the utility kernel of example 4. 25 (94) . the importance of habits. θt ) + βbEt u1 (c∗ − h∗ . where risk aversion is strongly increasing in b (cf. (73). The household’s coefficient of absolute risk aversion in Proposition 8. l Equations (91)–(92) have essentially the same form as the corresponding expressions in the model without habits. lt ) = V1 (at .

Indeed. or futures. the traditional measure can easily overstate risk aversion by a factor of three or more. should be useful to researchers interested in pricing any asset—stocks. closed-form expressions for risk aversion that this paper derives. and the methods of the paper more generally. Understanding how labor supply affects asset prices is thus important for bringing DSGE-type models closer to financial market data. asset prices in DSGE models can be very different and can behave very differently depending on how the household’s labor margin is specified. In these applications. even for expected utility preferences. households can even be risk neutral when the traditional measure of risk aversion is far from zero. bonds. The simple. The present paper suggests new ways of modeling risk neutrality in a DSGE framework. ignores the household’s ability to partially offset shocks to income with changes in hours worked. As a result. There is a wedge between the two concepts that depends on the household’s labor margin. risk neutrality allows for much simpler or even closed-form solutions to key aspects of the model. Discussion and Conclusions The ability to vary labor supply has dramatic effects on household risk aversion and asset prices in dynamic equilibrium models. Risk aversion matters for asset pricing. The traditional approach—linearity of utility in consumption—has undesirable implications for interest rates and consumption growth. −cu11 /u1 . in foreign or domestic currency—within the framework of . For reasonable parameterizations. A related observation is that risk aversion and the intertemporal elasticity of substitution are nonreciprocal. An extreme example of this is when household utility has a zero discriminant—implying risk neutrality—even when the traditional measure of risk aversion is large. but the present paper shows that any utility kernel with a zero discriminant can be used instead. and international literatures thus may be overstating the actual degree of risk aversion in their models by a substantial degree. macro-finance. The traditional measure of risk aversion. Many studies in the macroeconomics. such as labor market search or financial frictions. If risk aversion is measured incorrectly because the labor margin is ignored. then risk premia in the model are also more likely to be surprising or puzzling. Risk neutrality itself can be a desirable feature for some applications.31 5. Risk premia on assets computed using the stochastic discount factor are essentially linear in the degree of risk aversion.

Since these models are a mainstay of research in academia. at central banks. . the applicability of the results should be widespread.32 dynamic equilibrium models. and international financial institutions.

θt+1 )εt+1 = 0 because εt+1 is independent of θt+1 and a∗ . so that: ∗ V (at . Because (6) describes a one-shot gamble in period t. (A4) simplifies to: βEt V11 (a∗ . Thus. it t+1 t affects assets a∗ in period t + 1 but otherwise does not affect the household’s optimization problem t+1 from period t + 1 onward. note first that the household’s optimal choices for con∗ sumption and labor in period t. will generally depend on the size of the gamble σ—for t example. εt+1 is independent of θt+1 and a∗ . the linearized version of the model is certainty equivalent. σ) to emphasize this dependence on σ. The tilde over the V on the left-hand side of (A2) t+1 emphasizes that the form of the value function itself is different in period t due to the presence of the one-shot gamble in that period. alternatively. in ∗ this section we write c∗ ≡ c∗ (at . the effect of the gamble on household welfare is: u11 ∂c∗ ∂σ 2 + 2u12 ∂c∗ ∂l∗ + u22 ∂σ ∂σ ∂l∗ ∂σ 2 + u1 2 ∂ 2 c∗ ∂ 2 l∗ + u2 2 ∂σ 2 ∂σ ∂ 2 c∗ ∂ 2 l∗ − ∂σ 2 ∂σ 2 dσ 2 . the first-order cost of the gamble is zero. 2 (A4) + βEt V11 · wt ∂c∗ ∂l∗ − + εt+1 ∂σ ∂σ + βEt V1 · wt ∗ The terms involving ∂ 2 c∗ /∂σ 2 and ∂ 2 l∗ /∂σ 2 cancel due to the optimality of c∗ and lt . for infinitesimal gambles. lt ) + βEt V (a∗ . Et V1 (a∗ . σ) = u(c∗ . σ) and lt ≡ l∗ (at . θt+1 ) ε2 t+1 t+1 dσ 2 . Turning now to the gamble in (6). 2 (A5) Finally. t+1 1 + rt (A1) where the right-hand side of (A1) follows from the envelope theorem. θt . hence c∗ and l∗ must be symmetric about σ = 0. t+1 which does not depend on σ except through a∗ . the household’s value-to-go at time t also depends on σ. θt . t t+1 (A2) ∗ where a∗ ≡ (1 + rt )at + wt lt + dt − c∗ . θt . The derivatives t ∂c∗ /∂σ and ∂l∗ /∂σ vanish at σ = 0 (there are two ways to see this: first. Differentiating (A2) with respect to σ. θt+1 ). θt ) dμ = −βEt V1 (a∗ . Thus. the household’s value-to-go at time t + 1 is just V (a∗ . as in the usual envelope theorem (these derivatives vanish at σ = 0 anyway. the household may undertake precautionary saving when faced with this gamble.33 Appendix: Mathematical Derivations Proof of Proposition 1 For an infinitesimal fee dμ in (7). u2 . To second order. c∗ and lt . for the reasons discussed below). Moreover. We write this dependence out explicitly as well. Thus. θt+1 ) dμ . the gamble in (6) is isomorphic for positive and negative σ. as in Arrow (1964) and Pratt (1965). to first order. t ∗ ∗ Because ct and lt depend on σ. evaluating the latter at t+1 t+1 σ = 0. as a result. implying the derivatives vanish). evaluating the latter at σ = 0. the change in household welfare (5) is given. the first-order effect of the gamble on household welfare is: ∂c∗ ∂c∗ ∂l∗ ∂l∗ + u2 + βEt V1 · (wt − + εt+1 ) dσ. Since εt+1 has unit t+1 variance. Optimality of c∗ and t ∗ lt implies that the terms involving ∂c∗ /∂σ and ∂l∗ /∂σ in (A3) cancel. by: −V1 (at . (A6) t+1 2 . (A5) reduces to: dσ 2 βEt V11 (a∗ . θt+1 ) . and V1 are suppressed to simplify notation. θt+1 ). (A3) u1 ∂σ ∂σ ∂σ ∂σ where the arguments of u1 .

and Risk Premia Differentiating the household’s Euler equation (15) and evaluating at steady state yields: ∗ ∗ u11 (dc∗ − Et dc∗ ) + u12 (dlt − Et dlt+1 ) = βEt u1 drt+1 . θt+1 ) t+1 (A7) Recall that (A7) is already evaluated at σ = 0. becomes: (u11 − λu12 )(dc∗ − Et dc∗ ) − t t+1 u1 u12 (dwt − Et dwt+1 ) = βEt u1 drt+1 . . and solving for dc∗ .t+k . the Stochastic Discount Factor. Et dc∗ t+k = dc∗ t u1 u12 βu1 − (dwt − Et dwt+k ) − Et drt+i . we get the more general expression: dmt+1 = βr αu1 1 u11 − λu12 − u1 1 + wλ u ∞ ∞ dat+1 + Et+1 k=1 1 (l dwt+k + ddt+k + adrt+k ) (1 + r)k (A15) − βr Et+1 k=1 1 (1 + r)k λ dwt+k − d log Rt+1. 1 + wλ . for each k = 1. θt+1 ) t+1 . . is: − Et V11 (a∗ . Combining (35). set at+1 = a and θt+1 = θ to get: − V11 (a. (36).. . 2. θ) . applying (36). θ) Derivation of Risk Aversion. but dmt+1 has extra terms related to dVt+1 . t t+1 (A8) (A9) which.t+k . For generalized recursive preferences. u22 + wu12 k (A10) Note that (A10) implies. equations (A9)–(A13) still hold. Section 4. and evaluating at steady state yields: ∞ Et k=0 1 ∗ (dc∗ − wdlt+k − ldwt+k − ddt+k − adrt+k ) = (1 + r) dat . differentiating. In this case.1). Et V1 (a∗ . t+k k (1 + r) (A12) Substituting (36) and (A11) into (A12). 2 u11 − λu12 u11 u22 − u12 i=1 (A11) Combining (2)–(3). (A13) 1 + wλ where Rt. 2dμ/dσ 2 .t+k . so to evaluate it at the nonstochastic steady state. and (A13) gives: ∞ k=1 dmt+1 = βr u11 − λu12 1 dat+1 + Et+1 u1 1 + wλ ∞ 1 (l dwt+k + ddt+k + adrt+k ) (1 + r)k (A14) − βr Et+1 k=1 1 (1 + r)k λ dwt+k − d log Rt+1.34 Equating (A1) to (A6). 1 + wλ as in the main text. V1 (a.t+k ≡ + rt+i ). yields: t dc∗ = t + r 1 (1 + r)dat + Et 1 + r 1 + wλ ∞ k=0 1 (l dwt+k + ddt+k + adrt+k ) (1 + r)k ∞ r −u1 u1 u12 1 dwt + Et 2 1 + r u11 − λu12 (1 + r)k u11 u22 − u12 k=0 k i=1 (1 λ dwt+k − d log Rt. Equation (A14) also holds for the case of external habits (cf. the Arrow-Pratt coefficient of absolute risk aversion.

a∗ ) are slightly more complicated: t t+1 ∗ u1 (c∗ . However. θ) V (a. the first-order t+1 cost of the gamble is zero. θt+1 )1−α ) t t+1 ∗ u2 (c∗ . to evaluate it at the nonstochastic steady state. Et V −α V1 (A22) Since (A22) is already evaluated at σ = 0. To second order. the first-order effect of the gamble on household welfare is: ∂c∗ ∂c∗ ∂l∗ ∂l∗ α/(1−α) Et V −α V1 · (wt + u2 + β (Et V 1−α ) − + εt+1 ) dσ. the change in welfare for the household with generalized recursive preferences is: dμ α/(1−α) = −β (Et V (a∗ . (A23) V1 (a. t+1 t+1 Et V (a∗ . and V1 to simplify notation. the household’s optimality ∗ conditions for c∗ and lt (and. θt+1 ) t t+1 α/(1−α) Et V (a∗ . the terms involving ∂ 2 c∗ /∂σ 2 and ∂ 2 l∗ /∂σ 2 ∗ cancel due to the optimality of c∗ and lt . θ) +α . implicitly. (A20) simplifies to: dσ 2 . θt+1 ). t+1 t+1 ∗ −wt u1 (c∗ .35 Proof of Proposition 6 For generalized recursive preferences. θt+1 = θ to get: V1 (a. θt+1 )−α V1 (a∗ . ∂σ 2 ∂σ 2 ⎭ 2 α/(1−α) Et V −α V11 · wt (A20) The derivatives ∂c∗ /∂σ and ∂l∗ /∂σ vanish at σ = 0. u2 . θt ) t+1 t+1 t+1 1 + rt where the right-hand side of (A18) follows from the envelope theorem. lt ). the hypothetical one-shot gamble and one-time fee faced by the household are the same as for the case of expected utility. evaluating the latter at σ = 0. V . Thus. θ) . and Et V −α V1 εt+1 = 0 t because εt+1 is independent of θt+1 and a∗ . optimality ∗ of c∗ and lt implies that the terms involving ∂c∗ /∂σ and ∂l∗ /∂σ cancel. θt+1 )−α V1 (a∗ . lt ) t (A16) (A17) 1−α α/(1−α) ) Note that (A16) and (A17) are related by the usual = and when α = 0. For an infinitesimal fee dμ in (7). θt+1 ) dμ . 2 Equating (A18) to (A21). θt+1 )1−α ) Et V (a∗ . As before. (A18) −V1 (at . the Arrow-Pratt coefficient of absolute risk aversion is: β (Et V 1−α ) α/(1−α) Et V −α V11 − αEt V −α−1 V12 (A21) −Et V −α V11 + αEt V −α−1 V12 . Turning now to the gamble in (6). lt ) = β (Et V (a∗ . set at+1 = a. and εt+1 is independent of θt+1 and a∗ (evaluating the t t+1 latter at σ = 0). θ) −V11 (a. (A16) and (A17) reduce to the standard optimality conditions for expected utility. θt+1 ). t ∗ u2 (c∗ . (A19) ∂σ ∂σ ∂σ ∂σ where we have dropped the arguments of u1 . the effect of the gamble on household welfare is: ⎧ 2 2 ⎨ ∂c∗ ∂l∗ ∂ 2 c∗ ∂ 2 l∗ ∂c∗ ∂l∗ u11 + 2u12 + u1 + u2 + u22 ⎩ ∂σ ∂σ ∂σ ∂σ ∂σ 2 ∂σ 2 u1 + αβ (Et V 1−α ) − αβ (Et V 1−α ) + β (Et V 1−α ) (2α−1)/(1−α) Et V −α V1 · wt ∂c∗ ∂l∗ − + εt+1 ∂σ ∂σ 2 2 α/(1−α) Et V −α−1 V1 · wt ∂c∗ ∂l∗ − + εt+1 ∂σ ∂σ 2 ∂c∗ ∂l∗ − + εt+1 ∂σ ∂σ ⎫ 2 ∗ 2 ∗ ⎬ dσ 2 ∂ c ∂ l α/(1−α) + β (Et V 1−α ) Et V −α V1 · wt − . θt+1 )−α V1 (a∗ . lt ) = −βwt (Et V (a∗ . Thus.

(A30) t wt To solve for V11 . lτ ). differentiate (A30) with respect to at to yield: V11 (at . lτ ) = wτ [u1 (c∗ − h∗ . θt ) = − u2 (c∗ − ht . ∂at ∂at (A31) ∗ ∗ It remains to solve for ∂c∗ /∂at and ∂lt /∂at . τ τ τ τ τ τ (A34) (A35) = wτ (1 − βbF (1 − βρF ) −1 ) u1 (c∗ τ − ∗ h∗ . (A26) (A27) u2 = −βwt (Et V 1−α ) α/(1−α) where we drop the arguments of u and V to reduce notation. τ . lt ) + β Et V (a∗ . where now F denotes the “generalized recursive” forward operator. Note first that (A29) can be used to solve for V2 in terms of current and future marginal utility: V2 = −(1 − ρβF )−1 u1 . ht . (A25) with |ρ| < 1. We henceforth let a time subscript τ ≥ t denote a generic future date and reserve the subscript t to denote the date of the current period—the period in which the household faces the hypothetical one-shot gamble. (A24) and a longer-memory specification for habits: ht = ρht−1 + bct−1 . As in the main text. The household’s first-order conditions for (A24) with respect to consumption and labor are given by: u1 = β (Et V 1−α ) α/(1−α) Et V −α [V1 − bV2 ]. and we assume ρ + b < 1 in order to ensure h < c. lt ). ht . h∗ +1 . θt ) = − (1 + rt ) wt u12 ∂c∗ ∂l∗ t + u22 t . h∗ . we solve for ∂c∗ /∂at and ∂lτ /∂at t τ for all dates τ ≥ t at the same time. As in the main text. Et V −α (A28) (A29) 1−α α/(1−α) ) V2 . except τ that the expressions are more complicated due to the persistence of habits and the household’s more complicated discounting of future periods. F xτ ≡ (Eτ V 1−α ) α/(1−α) (A32) Eτ V −α xτ +1 . (A33) The household’s intratemporal optimality condition ((A28) combined with (A29)) implies: ∗ ∗ −u2 (c∗ − h∗ . ∗ We solve for ∂lτ /∂at in terms of ∂c∗ /∂at in the same manner as in the main text. that is. ht . We wish to compute V1 and V11 . θt+1 )1−α t t+1 t+1 1/(1−α) . Differentiating (A24) with respect to its first two arguments and applying the envelope theorem yields: V1 = β(1 + rt ) (Et V 1−α ) V2 = −u1 + ρβ (Et V α/(1−α) Et V −α V1 . lτ ) + bβEτ V2 (a∗ +1 . Equations (A26) and (A27) are the same as in the main text except that the discounting of future periods involves the value function V when α = 0. (A27) and (A28) can be used to solve for V1 in terms of current-period utility: (1 + rt ) ∗ V1 (at . θt ) = u(c∗ − ht .36 Derivation of Risk Aversion with Long-Memory Internal Habits and EZ Preferences We consider here the case of generalized recursive preferences: ∗ V (at . θτ +1 )]. Et V −α V1 .

we t must have: ∂c∗ ∂c∗ t+1 = (1 + b) t . ∂at (A45) ∗ which then holds for all τ ≥ t + 1. from (A40). The household’s intertemporal optimality (Euler) condition is given by: 1 + rτ 1 ∗ ∗ u2 (c∗ − h∗ . . ∂at ∂at Et (A46) (A47) . This solves for ∂lt /∂at in terms of (current and future) ∂c∗ /∂at . we can apply (1 − ρL) to both sides of (A43) to get: (1 − F ) [1 − (ρ + b)L] ∂c∗ τ = 0. whatever the initial responses ∂c∗ /∂at and ∂lt /∂at . k = 1. ∂at (A42) Equations (A41) and (A42) hold for all τ ≥ t. lτ ) = βF u2 (c∗ − h∗ . hence we can invert the [1 − β(ρ + b)F ] operator forward to get: ∂c∗ (A43) (1 − F ) [1 − bL(1 − ρL)−1 ] τ = 0. ∂at ∂l∗ (1 − F ) τ = 0.37 Differentiating (A35) with respect to at and evaluating at steady state yields: −u12 ∂h∗ ∂c∗ τ τ − ∂at ∂at − u22 ∗ ∂h∗ ∂lτ ∂c∗ τ τ = w (1 − βbF (1 − βρF )−1 ) u11 − ∂at ∂at ∂at + u12 ∗ ∂lτ . ∂at (A38) where we’ve used hτ = bL(1 − ρL)−1 cτ and we assume β (ρu22 + (ρ + b)wu12 )/(u22 + wu12 ) < 1 ∗ to ensure convergence. lτ ). ∂at ∂at ∗ ∗ ∂l ∂lt and Et t+k = . Thus. (A44) ∂at Finally. τ ∗ We now turn to solving for ∂cτ /∂at . ∂at ∂at ∂c∗ τ = 0. (A40) simplifies to: [1 − β(ρ + b)F ] (1 − F ) [1 − bL(1 − ρL)−1 ] which. (A39) τ τ τ τ wτ wτ Differentiating (A39) with respect to at and evaluating at steady state yields: u12 (1 − F ) [1 − bL(1 − ρL)−1 ] ∂l∗ ∂c∗ τ = −u22 (1 − F ) τ . ∂at ∂at ∂c∗ ∂c∗ Et t+k = (1 + b(ρ + b)k−1 ) t . (A36) ∂at where we have used the fact that: ∂xτ ∂ F xτ = F . . ∂at ∂at (A37) ∗ when the derivative is evaluated at steady state. also implies: (A41) [1 − β(ρ + b)F ] (1 − F ) ∗ ∂lτ = 0. 2. ∂at (A40) Using (A38) and noting F L = 1 at steady state. . Solving (A36) for ∂lτ /∂at yields: ∗ u12 + wu11 − β (ρu12 + (ρ + b)wu11 )F ∂lτ = − × ∂at u22 + wu12 1− β(ρu22 + (ρ + b)wu12 ) F u22 + wu12 −1 (1 − bL(1 − ρL)−1 ) ∂c∗ τ .

In order to express (A52) in terms of u1 and u11 instead of u2 and u22 . we use V1 = (1−β(ρ+b))u1 /(β(1− βρ)) and differentiate the first-order condition: ∗ V1 (at .38 Consumption responds gradually to a surprise change in wealth. = βb ∂at 1 + (1 − 1−βρ )wλ (A51) Without habits or labor. Together. ∂at ∂at (A48) where λ ≡ w(1 − β(ρ + b))u11 + (1 − βρ)u12 u1 u12 − u2 u11 = . (A53) Equations (A52) and (A53) have obvious similarities to the corresponding expressions without habits and with expected utility preferences. while labor moves immediately to its new steady-state level. ∗ It remains to solve for ∂ct /∂at . an increase in assets would cause consumption to rise by the amount of the income flow from the change in assets—the first term on the right-hand side of (A51). we can now solve (A40) to get: ∗ ∂c∗ ∂lt = −λ t . τ 26 with respect to at to solve for V11 . lτ ). which is accounted for by the denominator of the second term in (A51). The presence of habits attenuates this change by the amount βb/(1 − βρ) in the numerator of the second term. u1 u22 − u2 u12 (1 − βρ)u22 + w(1 − β(ρ + b))u12 (A49) u2 1−βρ where the latter equaltiy follows because w = − u1 1−β(ρ+b) in steady state. The household’s intertemporal budget constraint implies: ∞ Et τ =t (1 + r)−(τ −t) ∗ 1 + r ∂lt ∂c∗ τ = (1 + r) + w . (A48) and (A51) allow us to compute the household’s coefficient of absolute risk aversion (63) in Proposition 7:26 βb (1 − 1−βρ ) r βb r u1 V1 −u11 + λu12 −V11 1− . and the consumption response is further attenuated by the household’s change in hours worked. . + α +α = βb V1 V u1 u 1 − βρ 1 + (1 − 1−βρ )wλ (A52) The consumption-based coefficient of relative risk aversion is given by: βb (1 − 1−βρ ) c −AV11 c u1 AV1 −u11 + λu12 + α +α = βb V1 V u1 u 1 + (1 − 1−βρ )wλ 1− βb 1 − βρ . From (A46). θt ) = (1 + rt ) (1 − βbF (1 − βρF )−1 ) u1 (c∗ − hτ . ht . ∂at r ∂at (A50) Substituting (A46) and (A48) into (A50) and solving for ∂c∗ /∂at yields: t βb (1 − 1−βρ ) r ∂c∗ t .

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