The volatility trap: Precautionary saving, investment, and aggregate risk

• Author: Fuad Hasanov,Reda Cherif
• Published date: 01 April 2018
• Date: 01 April 2018
• DOI: http://doi.org/10.1002/ijfe.1610

RESEARCH ARTICLE

The volatility trap: Precautionary saving, investment, and

aggregate risk

Reda Cherif

1

| Fuad Hasanov

1,2

1

International Monetary Fund,

Washington, DC, USA

2

Georgetown University, Washington,

DC, USA

Correspondence

Fuad Hasanov, International Monetary

Fund, Washington, DC 20431, USA.

Email: fhasanov@imf.org

JEL Classification: E21; E22; D91; O40

Abstract

We study the effects of permanent and temporary income shocks on precau-

tionary saving and investment in a “store‐or‐sow”model of growth. High vola-

tility of permanent shocks results in high precautionary saving in the safe asset

and low investment or a “volatility trap,”namely, big savers invest relatively lit-

tle. In contrast, low volatility of permanent shocks leads to low precautionary

saving and high or low investment, depending on the volatility of temporary

shocks. Empirical evidence shows a nonlinear relationship between investment

and saving and that investment is a hump‐shaped function of the volatility of

permanent shocks, as predicted by the model.

KEYWORDS

buffer‐stock, growth, investment,precautionary saving, risk, volatility

1|INTRODUCTION

Studying the effect of aggregate risk on investment and

saving is important to understand how economies work.

In contrast to idiosyncratic risk, aggregate risk affects

the whole economy and is not insurable on a country

level. Although hedging instruments flourished since the

1990s, their use at the macro level remains marginal.

1

Meanwhile, the liberalization of trade and capital flows

may have amplified the effects of external shocks on the

economy. It is quite possible that aggregate risk plays a

central role in the investment‐saving dynamics at the

macroeconomic level. Low aggregate risk could explain

why the saving‐investment balance (or current account

balance) in advanced economies tends to be smaller than

that in emerging nations. Among other factors, an

increase in aggregate risk could explain the build‐up in

current account surpluses and international reserves in

Asian countries, following the 1997–1998 financial crisis.

2

In this paper, we explore the effect of aggregate income

risk on investment and saving.

Empirical evidence suggests a negative relationship

between the investment‐saving ratio and the saving rate

for a large cross‐section of countries.

3

Big savers invest

relatively little, and income volatility seems to be an

important driver of the investment and saving dynamics.

In particular, high volatility of permanent income shocks

induces countries to save a lot and invest relatively little.

Oil exporters are typically big savers and small investors

(Cherif & Hasanov, 2013, and van den Bremer & van der

Ploeg, 2012). Panel fixed effects regressions suggest that

the effect of volatility on investment differs, depending

on whether income shocks are permanent or temporary.

We analyse the impact of permanent/persistent and

temporary income shocks in a stylized model of

precautionary saving and optimal investment under

uncertainty. The model is related to the precautionary

saving model of Carroll (2001).

4

We study aggregate

rather than household dynamics and introduce invest-

ment. Our representative agent model thus features two

assets: a safe asset and risky capital. The investment rate

affects output/income growth, resembling the production

function in Barlevy (2004). Output is perturbed by perma-

nent and temporary shocks.

The International Monetary Fund retains copyright and all other rights

in the manuscript of this article as submitted for publication.

Received: 22 July 2015 Revised: 26 January 2016 Accepted: 19 December 2017

DOI: 10.1002/ijfe.1610

174 Copyright © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2018;23:174–185.wileyonlinelibrary.com/journal/ijfe