Intertemporal substitution, risk aversion, and economic performance in a stochastically growing open economy

The constant elasticity utility function implies that the intertemporal elasticity of substitution is the inverse of the coefficient of relative risk aversion. With empirical evidence suggesting that this relationship may or may not hold, studies of risk and growth should decouple these two parameters. This paper provides an analytical characterization and numerical simulations of the equilibrium of a stochastically growing small open economy under general recursive preferences. We show that errors committed by using the constant elasticity utility function, even for small violations of the compatibility condition, can be substantial. Our results suggest that the constant elasticity utility function should be employed with caution.