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Wealth in the Utility Function and Consumption Inequality

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  • Yulei Luo
  • Jun Nie
  • Heng-fu Zou

Abstract

Wealth in the utility function (WIU) has been increasingly used in macroeconomic models and this specification can be justified by a few theories such as Max Weber’s (1904-05, German; 1958) theory on “spirit of capitalism.” We incorporate the WIU into a general equilibrium consumption-portfolio choice model to study the implications of the WIU for consumption inequality, equilibrium interest rate, and equity premium—an unexplored area in the literature. Our general equilibrium framework features recursive exponential utility, uninsurable labor risks, and multiple assets and can deliver closed-form solutions to help disentangle the effects of the WIU in driving the key results. We show a stronger preference for wealth lowers the risk-free rate but increases the consumption inequality and equity premium in the equilibrium. We show these properties improve the model’s performance in explaining the data. We also compare the WIU with a closely related hypothesis, habit formation, and find that they have opposite effects on equilibrium asset returns and consumption inequality.

Suggested Citation

  • Yulei Luo & Jun Nie & Heng-fu Zou, 2021. "Wealth in the Utility Function and Consumption Inequality," Research Working Paper RWP 21-17, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:93600
    DOI: 10.18651/RWP2021-17
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    More about this item

    Keywords

    Wealth; Spirit of Capitalism; Risk free rates; Risk premia; Savings; Consumption inequality; Wealth inequality;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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