We generalize the Permanent Income Hypothesis (PIH) of Friedman (1957) with a large, negative income shock (LNIS). We quantify the required amount of pre-cautionary savings for consumption smoothing. We nd that with the LNIS, the precautionary savings could increase as wealth increases, consistent with the US data. We also provide a general equilibrium analysis with a focus on interest rate. The agent's demand for precautionary savings is sufficiently strong making her save at a high rate and thus lowering the equilibrium interest rate significantly, which is particularly relevant to today's low-interest-rate environment. Finally, the LNIS significantly improves our equilibrium model's ability to match the equity premium and risk-free rate of the century-long sample (1891-1994).​

Keywords: Income Shock, Incomplete Market, Consumption Smoothing, Precautionary Savings, General Equilibrium

JEL Codes: D15, D58, G11, G12