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Discounting the distant future: How much does model selection affect the certainty equivalent rate?

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  • Ekaterini Panopoulou

    ()
    (Department of Banking and Financial Management, University of Piraeus, Greece and Department of Economics, National University of Ireland Maynooth.)

  • B. Groom

    (Department of Economics, University College London.)

  • P. Koundouri

    (Department of Economics, University of Reading, UK and Department of Economics, University College London, UK.)

  • Theologos Pantelidis

    (Department of Banking and Financial Management, University of Piraeus, Greece.)

Abstract

Evaluating investments with long-term consequences using discount rates that decline with the time horizon, (Declining Discount Rates or DDRs) means that future welfare changes are of greater consequence in present value terms. Recent work in this area has turned towards operationalising the theory and establishing a schedule of DDRs for use in cost benefit analysis. Using US data we make the following points concerning this transition: i) model selection has important implications for operationalising a theory of DDRs that depends upon uncertainty; ii) misspecification testing naturally leads to employing models that account for changes in the interest rate generating mechanism. Lastly, we provide an analysis of the policy implications of DDRs in the context of climate change for the US and show that the use of a state space model can increase valuations by 150% compared to conventional constant discounting.

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Bibliographic Info

Paper provided by Department of Economics, Finance and Accounting, National University of Ireland - Maynooth in its series Economics, Finance and Accounting Department Working Paper Series with number n1480105.

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Length: 28 pages
Date of creation: Jan 2005
Date of revision:
Handle: RePEc:may:mayecw:n1480105

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Postal: Maynooth, Co. Kildare
Phone: 353-1-7083728
Fax: 353-1-7083934
Web page: http://economics.nuim.ie
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Keywords: long-run discounting; interest rate forecasting; interest rate forecasting; state-space models; regime-switching models; climate change policy;

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