Federal Reserve Bank of Kansas City

A growing body of literature has suggested that agents ’ risk attitudes may not be constant and are correlated with factors such as wealth. We introduce state-dependent risk aversion into Aiyagari’s (1994) heterogenous-agent version of standard neoclassical growth model with unin-surable idiosyncratic shocks to earning. We first quantitatively show the relationships among risk aversion, saving rate, equilibrium interest rate and wealth distribution. In particular, we show that if agent’s risk aversion increases with wealth, the model predicts a larger wealth inequality, while assuming risk decreases with wealth leads to a smaller wealth inequality. We then use experimental data to estimate how risk aversion is correlated with an individual’s wealth. We found that the relationship between risk aversion and wealth is hump-shaped. That is, risk aversion first increases with an individual’s wealth and then decreases with it. Using the same model, we quantify the implication of this relationship between risk aversion and wealth on wealth inequality. The results show that the overall wealth inequality changes very little compared to the case with constant risk aversion. This is because, though the poorest agents save less, which increases wealth inequality, the richest agents also save less