Risk aversion, intertemporal substitution, and the aggregate investment–uncertainty relationship

Abstract

We analyze the role of risk aversion and intertemporal substitution in a simple dynamic general equilibrium model of investment and savings. Our main finding is that risk aversion cannot by itself explain a negative relationship between aggregate investment and aggregate uncertainty, as the effect of increased uncertainty on investment also depends on the intertemporal elasticity of substitution. In particular, the relationship between aggregate investment and aggregate uncertainty is positive even if agents are very risk averse, as long as the elasticity of intertemporal substitution is low. A negative investment–uncertainty relationship requires that the relative risk aversion and the elasticity of intertemporal substitution are both relatively high or both relatively low. We also show that the implications of our model are consistent with the available empirical evidence.