Ignorance, Pervasive Uncertainty, and Household Finance

Abstract

This paper studies how the two types of uncertainty due to ignorance, parameter and model uncertainty, jointly affect strategic consumption-portfolio rules, precautionary savings, and welfare. We incorporate these two types of uncertainty into a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth, and derive analytical solutions and testable implications. We show that the interaction between the two types of uncertainty plays a key role in determining the demand for precautionary savings and risky assets. We derive formulas to evaluate both marginal and total welfare costs of ignorance-induced uncertainty and show they are significant for plausible parameter values.