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Rules of thumb in life-cycle savings models

  • Rodepeter, Ralf

    (Sonderforschungsbereich 504)

  • Winter, Joachim

    ()

    (Mannheim Research Institute for the Economics of Aging (MEA))

We analyze life-cycle savings decisions when households use simple heuristics, or rules of thumb, rather than solve the underlying intertemporal optimization problem. The decision rules we explore are a simple Keynesian rule where consumption follows income; a simple consumption rule where only a fraction of positive income shocks is saved; a rule that corresponds to the permanent income hypothesis; and two rules that have been found in experimental studies. Using these rules, we simulate life-cycle savings decisions numerically and compute the utility losses relative to the backwards solution of the intertemporal optimization problem. Our central finding is that the utility losses induced by rule-of-thumb behavior are relatively low. We conclude that behaving optimally, in the sense of solving an intertemporal optimization model, is not only costly, it is also not much better than using simple heuristics. Our results might also explain why optimization models typically fit the main features of empirical data quite well although optimizing behavior itself is frequently rejected.

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Paper provided by Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim in its series Sonderforschungsbereich 504 Publications with number 99-81.

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Length: 30 pages
Date of creation: 01 Oct 1999
Date of revision:
Handle: RePEc:xrs:sfbmaa:99-81
Note: Financial Support from Deutsche Forschungsgemeinschaft, SFB 504 at the University of Mannheim, is gratefully acknowledged.
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  11. Deaton, A., 1989. "Saving And Liquidity Constraints," Papers 153, Princeton, Woodrow Wilson School - Public and International Affairs.
  12. Harald Uhlig & Martin Lettau, 1999. "Rules of Thumb versus Dynamic Programming," American Economic Review, American Economic Association, vol. 89(1), pages 148-174, March.
  13. Ingram, Beth Fisher, 1990. "Equilibrium Modeling of Asset Prices: Rationality versus Rules of Thumb," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 115-25, January.
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