Asset Smoothing, Consumption Smoothing and the Reproduction for Inequality under Risk and Subsistence Constraints

This paper uses a stochastic dynamic programming model to explore savings and portfolio decisions in an environment in which both yield risk and endogenous asset-price risk exist, and a subsistence constraint creates an inter-temporal link between current consumption and future labor power. Numerical analysis of the model shows that optimal portfolio strategies bifurcate. Initially wealthier agents acquire a higher yielding portfolio and pursue a conventional consumption-smoothing strategy. Initially poorer agents acquire a safer, but less remunerative portfolio and pursue a defensive strategy characterized by asset-smoothing, rather than by consumption-smoothing. The positive correlation between initial wealth and rate of return on wealth that is created by these behaviors implies that inequality reproduces itself over time, and that while asset-based risk-coping is expensive for all agents, it is more so for the poor who forego 18% of their potential income in order manage risk.