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Consumption Paths under Prospect Utility in an Optimal Growth Model

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  • Reto Foellmi
  • Rina Rosenblatt-Wisch
  • Klaus Reiner Schenk-Hoppé

Abstract

This paper studies the Cass-Koopmans-Ramsey model of optimal economic growth in the presence of loss aversion and habit formation. The representative agent's preferences for consumption can be gradually varied between the standard constant intertemporal elasticity of substitution (CIES) case and Kahneman and Tversky's prospect utility. We find that the transitional dynamics of optimal consumption paths differ distinctly from the standard model, in particular consumption smoothing is more pronounced. We also show that prospect utility can cause the economy to remain in a steady state with low consumption and low capital.

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Bibliographic Info

Paper provided by Universitaet Bern, Departement Volkswirtschaft in its series Diskussionsschriften with number dp1010.

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Date of creation: Aug 2010
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Handle: RePEc:ube:dpvwib:dp1010

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Keywords: Ramsey growth model; prospect theory; loss aversion; optimal consumption;

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References

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  1. Rosenblatt-Wisch, Rina, 2008. "Loss aversion in aggregate macroeconomic time series," European Economic Review, Elsevier, vol. 52(7), pages 1140-1159, October.
  2. Laibson, David I., 1997. "Golden Eggs and Hyperbolic Discounting," Scholarly Articles 4481499, Harvard University Department of Economics.
  3. de La Croix, D. & Michel, P., 1997. "Optimal Growth When Tastes Are Inherited," G.R.E.Q.A.M. 97a21, Universite Aix-Marseille III.
  4. Andrew E. Clark and Andrew J. Oswald, . "Satisfaction and Comparison Income," Economics Discussion Papers 419, University of Essex, Department of Economics.
  5. Francisco Alvarez-Cuadrado & Goncalo Monteiro & Stephen Turnovsky, 2004. "Habit Formation, Catching Up with the Joneses, and Economic Growth," Working Papers UWEC-2004-09-P, University of Washington, Department of Economics, revised Jan 2004.
  6. Robert J. Barro, 1999. "Ramsey Meets Laibson In The Neoclassical Growth Model," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1125-1152, November.
  7. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 1-53, February.
  8. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  9. Boyer, Marcel, 1978. "A Habit Forming Optimal Growth Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 19(3), pages 585-609, October.
  10. Yaniv, Gideon, 1999. "Tax Compliance and Advance Tax Payments: A Prospect Theory Analysis," National Tax Journal, National Tax Association, vol. 52(n. 4), pages 753-64, December .
  11. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  12. Shi, Shouyong & Epstein, Larry G, 1993. "Habits and Time Preference," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(1), pages 61-84, February.
  13. Easterlin, Richard A, 2001. "Income and Happiness: Towards an Unified Theory," Economic Journal, Royal Economic Society, vol. 111(473), pages 465-84, July.
  14. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  15. Surico, Paolo, 2007. "The Fed's monetary policy rule and U.S. inflation: The case of asymmetric preferences," Journal of Economic Dynamics and Control, Elsevier, vol. 31(1), pages 305-324, January.
  16. Frank, Robert H, 1997. "The Frame of Reference as a Public Good," Economic Journal, Royal Economic Society, vol. 107(445), pages 1832-47, November.
  17. Easterlin, Richard A., 1995. "Will raising the incomes of all increase the happiness of all?," Journal of Economic Behavior & Organization, Elsevier, vol. 27(1), pages 35-47, June.
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Cited by:
  1. Lena Dräger & Jan-Oliver Menz & Ulrich Fritsche, . "Perceived Inflation under Loss Aversion," Macroeconomics and Finance Series 201105, Hamburg University, Department Wirtschaft und Politik.
  2. Rina Rosenblatt-Wisch, 2007. "Loss Aversion in Aggregate Macroeconomic Time Series," Working Papers 2007-06, Swiss National Bank.
  3. Keith Blackburn & David Chivers, 2013. "Fearing the Worst: The Importance of Uncertainty for Inequality," Centre for Growth and Business Cycle Research Discussion Paper Series 182, Economics, The Univeristy of Manchester.

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