Risk and Consumption

This paper offers an overview of the links between risk and consumption that are discussed in the theoretical literature and the empirical support these theories have received. In the theoretical literature we find two mechanisms whereby risk affects consumption. The first is precautionary saving. Greater risk regarding future income may lead to increased saving to create a buffer against potential bad events in the future. The second mechanism builds on the existence of transaction costs for durables. If it is costly to reverse a purchase of a durable, this creates a value of waiting for more information about future earnings and prices before making the purchase decision. This value may increase as risk increases so that a shift to higher risk may cause consumers to postpone purchases. In an empirical application, the relation between variations in financial volatility and consumption in Sweden is also investigated. Increased financial volatility is found to have a strong negative effect of on new car registrations.