Intertemporal Substitution, Risk Aversion, and Economic Performance in a Stochastically Growing Open Economy

Most intertemporal studies of risk are based on the constant relative risk aversion utility function. This has the property that the intertemporal elasticity of substitution and the coefficient of relative risk aversion are both consstant and inverses of each other. With the diversity of empirical evidence suggesting that this constraint may or may not be met, it is important that studies of risk and growth decouple these two parameters, which impinge on the equilibrium in distinct and in some respects conflicting ways. This paper provides both an analytical characterization as well as extensive numerical simulations of the euqilibrium in a stochastically growing small open economy under more general recursive preferences. The paper shows that errors committed by using the constant elasticity uility function rather than the more general recursive preferences, even for small violations of the compatibility condition within empirically plausible range of the parameter values can be both quantitatively and even qualitatively substantial.