Consumption commitments and precautionary savings

In incomplete market models, agents with homothetic preferences over one non-durable consumption good and exposed to idiosyncratic income shocks use precautionary savings as an instrument to smooth consumption across different contingencies. The magnitude and role of precautionary savings is therefore essential in the understanding of savings behavior of agents in such an economy. In this dissertation, I study the effects of consumption commitments on aggregate savings behavior within an otherwise standard incomplete market framework. In the first chapter, I explore the impact of a consumption commitment good like housing in an incomplete market framework (Aiyagari(1994), Huggett(1997)). Conceptually, I concentrate on the argument whether consumption of housing is associated with changes in risk aversion and therefore reflected in precautionary savings behavior of agents. I study an analytical framework that captures key elements in the data like (i) heterogeneity in earnings through fixed effects and uninsurable idiosyncratic shocks, (ii) fraction of income spent on housing, (iii) magnitude of moving costs. In the second chapter, I present a dynamic incomplete market model with a key feature: a commitment good (housing) with positive transaction (moving) costs. I focus on a stationary recursive equilibrium for agents in the benchmark economy. I calibrate the benchmark model to the US economy. I find that the benchmark economy replicates (i) the fraction of income spent on housing services, (ii) the fraction of people moving in each period. In the third chapter, I quantitatively evaluate the magnitude of precautionary savings in the presence of housing consumption in the benchmark economy and compare it to the standard incomplete market model. Results indicate that the presence of housing leads to higher aggregate precautionary savings by nearly 13% when compared to the Aiyagari specification. I find transaction costs to have significant impact on aggregate savings behavior.