Limited Participation and Consumption-Saving Puzzles: A Simple Explanation and the Role of Insurance

In this paper, we use a simple model to illustrate that the existence of a large, negative wealth shock and insufficient insurance against such a shock can potentially explain both the limited stock market participation puzzle and the low-consumption-high-savings puzzle that are widely documented in the literature. We then conduct an extensive empirical analysis on the relation between household portfolio choices and access to private insurance and various types of government safety nets, including social security and unemployment insurance. The empirical results demonstrate that a lack of insurance against large, negative wealth shocks is strongly correlated with lower participation rates and higher saving rates. Overall, the evidence suggests an important role of insurance in household investment and savings decisions.

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