Precautionary saving and partially observed income $

I propose an intertemporal precautionary saving model in which the agent’s labor income is subject to (possibly correlated) shocks with different degrees of persistence and volatility. However, he only observes his total income, not individual components. I show that partial observability of individual components of income gives rise to additional precautionary saving due to estimation risk, the error associated with estimating individual components of income. This additional precautionary saving is higher, when estimation risk is greater. Compared with a precautionary agent who is otherwise identical, but ignores estimation risk, the rational agent consumes less at the beginning of his life, but consumes more later, because of larger wealth accumulated from savings for estimation risk. The utility cost of ignoring estimation risk is also quantified in closed form. r 2004 Elsevier B.V. All rights reserved. JEL classification: D11; D91; E21