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Expectations-Based Reference-Dependent Life-Cycle Consumption

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  • Pagel, Michaela

Abstract

I incorporate expectations-based reference-dependent preferences into a dynamic stochastic model to explain three major life-cycle consumption facts; the intuitions behind these three implications constitute novel connections between recent advances in behavioral economics and prominent ideas in the macro consumption literature. First, expectations-based loss aversion rationalizes excess smoothness and sensitivity in consumption, the puzzling empirical observation of lagged consumption responses to income shocks. Intuitively, in the event of an adverse shock, the agent delays painful cuts in consumption to allow his reference point to decrease. Second, the preferences generate a hump-shaped consumption profile. Early in life, consumption is low due to a first-order precautionary-savings motive, but as uncertainty resolves, this motive is dominated by time-inconsistent overconsumption, forcing consumption to decline toward the end of life. Third, consumption drops at retirement. When uncertainty is absent, the agent does not overconsume because he dislikes the associated certain loss in future consumption. Additionally, I obtain several new predictions about consumption; compare the preferences with habit formation, hyperbolic discounting, and temptation disutility; and structurally estimate the preference parameters.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 47138.

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Date of creation: 15 Feb 2013
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Handle: RePEc:pra:mprapa:47138

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Keywords: Expectations-based reference-dependent preferences; life-cycle consumption; excess smoothness; excess sensitivity;

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Cited by:
  1. Driscoll, John C. & Holden, Steinar, 2014. "Behavioral Economics and Macroeconomic Models," Finance and Economics Discussion Series 2014-43, Board of Governors of the Federal Reserve System (U.S.).
  2. Nicholas C. Barberis, 2013. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," Journal of Economic Perspectives, American Economic Association, vol. 27(1), pages 173-96, Winter.
  3. Nicholas C. Barberis, 2012. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," NBER Working Papers 18621, National Bureau of Economic Research, Inc.

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