Economic insecurity, memory effects and allocations choices

Overview & Synopsis

This paper presents a macrodynamic model to examine economic insecurity, incorporating the effects of habit formation on consumption and investment decisions in the face of stochastic economic shocks. We extend the existing literature by formulating an intertemporal optimization framework in which agents face Poisson-type shocks and exhibit finite memory regarding their consumption habits. Our model quantifies economic insecurity through the optimal willingness to pay to reduce the intensity of these shocks, linking it, on the one hand, to macroeconomic parameters such as productivity and accumulated wealth, and on the other, to preferences and habit formation parameters. Key findings reveal that consumption habits significantly affect economic insecurity, which, ceteris paribus, is higher in contexts where habits are stronger, more persistent, and where habit memory is longer. Insecurity is also more pronounced when the same level of wealth is associated with a higher level of habitual consumption. At the same time, economic insecurity increases with longer expected recovery times from shocks, underscoring the role of past financial behavior and wealth accumulation as buffers against economic uncertainty.The model also enables an analysis of how shocks impact resource allocation, distinguishing agents' efforts to hedge against future shocks from their investments in productive activities. This distinction allows the model to reproduce more realistic investment dynamics compared to frameworks where precautionary saving primarily drives increases in aggregate investment.From a technical perspective, to the best of our knowledge, we present the first fully solved optimal control problem derived from a dynamic economic model with forwardlooking agents, finite memory (and thus a state equation with delay), and a Poisson process.