Stochastic maximum principle with Lagrange multipliers and optimal consumption with Lévy wage
Espen Stokkereit and Kristina Rognlien Dahl.
Afrika Matematika, volume 27, issue 3-4, pp. 555-572, June 2016.
We show how a stochastic version of the Lagrange multiplier method can be combined with the stochastic maximum principle for jump diffusions to solve certain constrained stochastic optimal control problems. Two different terminal constraints are considered; one constraint holds in expectation and the other almost surely. As an application of this method, we study the effects of inflation- and wage risk on optimal consumption. To do this, we consider the optimal consumption problem for a budget constrained agent with a Lévy income process and stochastic inflation. The agent must choose a consumption path such that his wealth process satisfies the terminal constraint. We find expressions for the optimal consumption of the agent in the case of CRRA utility, and give an economic interpretation of the adjoint processes.