Risk-sensitive preferences and age-dependent risk aversion

People in different age groups have shown to differ in their degrees of risk aversion. This
study investigates the macroeconomic implications of population aging when households
are assumed to be increasingly risk-averse in future utility when they age. The model
incorporates risk-sensitive preferences used in Hansen & Sargent (1995), which is the
only recursive preferences that can separate risk aversion and intertemporal elasticity of
substitution while being monotonic, into a 16-generation discrete-time OLG model with
undiversifiable income risk. Compared to a time-additive counterpart, risk-sensitive
preferences capture precautionary saving motive that exacerbates adverse responses of
aggregate macroeconomic variables under a population aging scenario through
demographic re-weighting and life-cycle redistribution channels. Varying risk aversion
also allows households to internalize future uncertainties when evaluating their welfare
impacts of demographic change, resulting in non-monotonic welfare dynamics with
higher welfare loss under a high-risk environment and vice versa. Risk-sensitive
preferences with age-dependent risk aversion can play an important role in optimal
policy settings by introducing uncertainties into the welfare impact analysis, while taking
into account more realistic risk-taking behavior of different age cohorts.