This empirical paper deals with the impacts of sentiment about the future, short-run risk, and long-run risk in a dynamic economic model of optimal consumption decisions with Schroder and Skiadas [(1999) Journal of Economic Theory 89, 68–126.] continuous-time stochastic recursive preferences. The empirical strategy combines both a latent factor method and a democratic orthogonalization technique. The latent factor method is applied to a large database of macroeconomic indicators, and a democratic orthogonalization technique is used to separate the relative importance of sentiment about the future and long-run risk channels in shaping optimal consumption decisions. The empirical results suggest that consumers with recursive preferences are not indifferent to long-run uncertainty shocks to future consumption prospects. Endogenous consumption variations are driven by a multicomponent mechanism, where on average, the sentiment component accounts for 15.33%, the short-run risk accounts for 16.89%, and the long-run risk pertains to 34.51%.

I examine whether an RBC model can generate a higher volatility of consumption relative to output, a strong negative correlation between output and the trade balance, and a weak countercyclicality of the real interest rate, phenomena that have been observed in the business cycles of emerging economies, including Korea. From an RBC model with recursive utility, I show that it is not the degree of relative risk aversion, but the elasticity of intertemporal substitution (EIS), that governs the movements of the variables of the model in the log linearized environment. The Bayesian estimation results based on Korean data from the period 1987 to 2013 suggest that there are some elements of success in describing the Korean economy based on the simple RBC model both with the EIS larger than one and with an error term for the real interest rate equation. An EIS larger than one improves the performance of the simple RBC model mainly in the direction of raising the volatility of consumption relative to output. Simulation results show that the error term for the real interest rate process mostly reflects the endogenous channel of financial frictions where the domestic real interest rate depends negatively on the expected (transitory) productivity shock.

We analyze optimal consumption and pension insurance during the life time of a consumer using the life cycle model, when the consumer has recursive utility. The relationship between substitution of consumption and risk aversion is highlighted, and clarified by the introduction of this type of preferences. We illustrate how recursive utility can be used to explain the empirical consumption puzzle for aggregates. This indicates a plausible choice for the parameters of the utility function, relevant for the consumer in the life cycle model. Optimal life insurance is considered, as well as the portfolio choice problem related to optimal exposures in risky securities. A major finding is that it is optimal for the typical insurance buyer to smooth adverse shocks to the financial market, unlike what is implied by the conventional model. This has implications for what type of contracts the life and pension insurance industry should offer.

This paper provides estimates of the welfare cost of volatility attributable to monetary and fiscal policy shocks. It uses a continuous-time stochastic dynamic general equilibrium model based on a recursive utility function that disentangles risk aversion from intertemporal substitution. We find that monetary and fiscal policy shocks may lead to opposite welfare effects: negative for monetary growth shocks, but positive for government expenditure shocks. Furthermore, we find that welfare costs are sensitive to the parameter values chosen for risk aversion and intertemporal substitution, and we conclude that welfare costs are potentially much larger than that found by Lucas, forcing some modification of the policy conclusions associated with Lucas's pioneering work.