Present Bias, Cognitive Bias, and Illiquid Savings

This paper analyzes consumption and savings of households, who may engage in myopic excess consumption due to present bias, but can also allocate funds into illiquid savings to self-control their consumption. In particular, I focus on situations where households have cognitive biases that lead them to be overconfident so that their present bias can be mitigated in the future, thus leading to inadequate self-control. To contend with this, the government can set a penalty rate for early withdrawals of semi-illiquid savings. The government can also set a subsidy rate for semi-illiquid and fully illiquid savings. These two policy variables are set socially optimally from a paternalistic perspective. In addition, I address cases where households are subject to mental accounting in their consumption with early withdrawals. The analysis will be conducted numerically by constructing a three-period model consisting of households with heterogeneous cognitive biases. Based on the model, I will examine the characteristics of household consumption and savings in different settings, their impact on welfare, the function of illiquid savings, and optimal policy.