A general equilibrium model of dynamic loss aversion

A multi-self model of dynamic loss aversion is developed to explore consumption dynamics in a calibrated general equilibrium for consumers whose utility depends on gain-loss feelings relative to their reference expectations. The model is versatile enough not only to fit the consumption data without resorting to any other mechanism than the preference, but also to reconcile consumption smoothing motivation with the nonmonotonic lifecycle consumption in data. This paper demonstrates that the key mechanism of the flexibility comes from the dual value function for gains and losses, which makes the nonmonotonic profile feasible, as well as the model’s descriptive property by which any plan of non-standard consumption behaviors is incorporated into the optimization procedure. Moreover, using a modified model in which the reference dependent consumers are restricted in their ability to foresee their future income flow, this paper provides an insight into loss aversion over a lifecycle implied from the income flow. When the model is extended to an environment under uncertainty, wherein the key mechanisms are well preserved, a negative saving is observed for a small income uncertainty, implying the precautionary-saving motive is compromised by overconsumption intention.