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CEP Discussion Paper
Consumption Smoothing and the Welfare Cost of Uncertainty
Yonas Alem and Jonathan Colmer
August 2015
Paper No' CEPDP1369:
Full Paper (pdf)

JEL Classification: I131; O13; Q12; Q56

Tags: uncertainty; consumption smoothing; subjective well-being; rainfall variability

Separating the effects of uncertainty from realised events, and identifying the welfare effects of uncertainty, present a number of empirical challenges. Combining individual-level panel data from rural Ethiopia with high-resolution meteorological data, we introduce a new proxy for income uncertainty - mean-preserving rainfall variability - and estimate that an increase in income uncertainty is associated with reductions in objective consumption and subjective well-being (SWB). Furthermore, 86% of the effect on SWB is attributed to the direct effects of uncertainty, consistent with a model of optimal expectations (Brunnermeier and Parker, 2005). In addition, we find that farmers in more uncertain environments are more resilient to realised rainfall shocks, consistent with a trade-off between optimism about the future and risk-management investments today. These findings suggest that the gains from further consumption smoothing are likely greater than estimates based solely on realised consumption fluctuations.