Consumption and saving decisions affect asset and credit markets and are an important variable in determining investment. In this chapter, we will describe some key aspects of saving and consumption in a deterministic setting. We will then turn to uncertainty.

In the recent literature, there has been more emphasis placed on examining consumption and saving decisions and asset-pricing relations in a unified manner. As we have described in earlier chapters, the general equilibrium asset-pricing approach implies that random payoff streams are priced with respect to consumption risk. Thus, an asset is considered risky if it yields low returns in states when consumption is also low. The choice of consumption and saving in an environment with multiple assets is also a portfolio choice problem. Hence, it appears crucial to provide a simple framework to link these issues before proceeding to the more formal models considered in later parts of this book.

In this chapter, we provide an introduction to the study of optimal consumption and saving decisions in an intertemporal context. As part of this analysis, we define the notion of consumption smoothing and illustrate the role of saving in the consumer's intertemporal choice problem. We also generalize the simple portfolio choice problem that we used to derive the CAPM, and consider the joint determination of consumption and asset choices with labor income. Finally, we use the consumer's intertemporal choice problem under uncertainty to examine the role of uncertainty and precautionary saving.