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Overconfidence and Consumption over the Life Cycle

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  • Frank Caliendo

    ()
    (Department of Economics, Colorado State University)

  • Kevin X.D. Huang

    ()
    (Department of Economics, Vanderbilt University)

Abstract

Overconfidence is a widely documented phenomenon. In this paper, we study the implications of consumer overconfidence in a life-cycle consumption/saving model. Our main analytical result is a necessary and sufficient condition under which any degree of overconfidence concerning the mean return on savings can produce a hump in the work-life consumption profile. This condition is almost always met in the data. We show by simulations that overconfidence concerning the variance of the return can have little effect on the long-run average behavior of consumption over the life cycle, and that our basic conclusion is fairly robust with various realistic modifications to the baseline model. We interpret the general applicability of our analytical framework and discuss our numerical results in the light of aggregate consumption data.

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Bibliographic Info

Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 0712.

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Date of creation: Aug 2007
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Handle: RePEc:van:wpaper:0712

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Web page: http://www.vanderbilt.edu/econ/wparchive/index.html

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Keywords: Overconfidence; consumption; life cycle; time inconsistency; hump shape; elasticity of intertemporal substitution ;

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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. Kevin Huang & Frank Caliendo, 2011. "Rationalizing multiple consumption-saving puzzles in a unified framework," Frontiers of Economics in China, Springer, vol. 6(3), pages 359-388, September.
  3. Shantanu Bagchi, 2011. "Can overconfidence explain the consumption hump?," Journal of Economics and Finance, Springer, vol. 35(1), pages 41-70, January.

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