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Yes, we should discount the far-distant future at its lowest possible rate: a resolution of the Weitzman-Gollier puzzle

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  • Freeman, Mark C.

Abstract

In this paper the author proves that the Expected Net Future Value (ENFV) criterion can lead a risk neutral social planner to reject projects that increase expected utility. By contrast, the Expected Net Present Value (ENPV) rule correctly identifies the economic value of the project. While the ENFV increases with uncertainty over future interest rates, the expected utility decreases because of the planner's desire to smooth consumption across time. This paper therefore shows that Weitzman (1998) is right and that, within his economy, the far-distant future should be discounted at its lowest possible rate.

Suggested Citation

  • Freeman, Mark C., 2009. "Yes, we should discount the far-distant future at its lowest possible rate: a resolution of the Weitzman-Gollier puzzle," Economics Discussion Papers 2009-42, Kiel Institute for the World Economy (IfW).
  • Handle: RePEc:zbw:ifwedp:200942
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    References listed on IDEAS

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    1. Christian Gollier & Phoebe Koundouri & Theologos Pantelidis, 2008. "Declining discount rates: Economic justifications and implications for long-run policy," Economic Policy, CEPR;CES;MSH, vol. 23, pages 757-795, October.
    2. Hepburn, Cameron & Groom, Ben, 2007. "Gamma discounting and expected net future value," Journal of Environmental Economics and Management, Elsevier, vol. 53(1), pages 99-109, January.
    3. Gollier, Christian, 2004. "Maximizing the expected net future value as an alternative strategy to gamma discounting," Finance Research Letters, Elsevier, vol. 1(2), pages 85-89, June.
    4. Gollier, Christian, 2010. "Expected net present value, expected net future value, and the Ramsey rule," Journal of Environmental Economics and Management, Elsevier, vol. 59(2), pages 142-148, March.
    5. Newell, Richard G. & Pizer, William A., 2003. "Discounting the distant future: how much do uncertain rates increase valuations?," Journal of Environmental Economics and Management, Elsevier, vol. 46(1), pages 52-71, July.
    6. Wolfgang Buchholz & Jan Schumacher, 2008. "Discounting the Long-Distant Future: A Simple Explanation for the Weitzman-Gollier-Puzzle," CESifo Working Paper Series 2357, CESifo Group Munich.
    7. Phoebe Koundouri & Theologos Pantelidis & Ben Groom & Ekaterini Panopoulou, 2007. "Discounting the distant future: How much does model selection affect the certainty equivalent rate?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(3), pages 641-656.
    8. Martin L. Weitzman, 2007. "A Review of the Stern Review on the Economics of Climate Change," Journal of Economic Literature, American Economic Association, vol. 45(3), pages 703-724, September.
    9. Freeman, Mark C., 2009. "The practice of estimating the term structure of discount rates," Global Finance Journal, Elsevier, vol. 19(3), pages 219-234.
    10. Gollier, Christian, 2009. "Should we Discount the Far-Distant Future at its Lowest Possible Rate?," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 3, pages 1-14.
    11. Eric Jacquier & Alex Kane & Alan J. Marcus, 2005. "Optimal Estimation of the Risk Premium for the Long Run and Asset Allocation: A Case of Compounded Estimation Risk," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 3(1), pages 37-55.
    12. Martin L. Weitzman, 2001. "Gamma Discounting," American Economic Review, American Economic Association, vol. 91(1), pages 260-271, March.
    13. Gollier, Christian, 2002. "Discounting an uncertain future," Journal of Public Economics, Elsevier, vol. 85(2), pages 149-166, August.
    14. Andrew Ang & Jun Liu, 2004. "How to Discount Cashflows with Time-Varying Expected Returns," Journal of Finance, American Finance Association, vol. 59(6), pages 2745-2783, December.
    15. Partha Dasgupta, 2008. "Discounting climate change," Journal of Risk and Uncertainty, Springer, vol. 37(2), pages 141-169, December.
    16. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    17. Weitzman, Martin L., 1998. "Why the Far-Distant Future Should Be Discounted at Its Lowest Possible Rate," Journal of Environmental Economics and Management, Elsevier, vol. 36(3), pages 201-208, November.
    18. William D. Nordhaus, 2007. "A Review of the Stern Review on the Economics of Climate Change," Journal of Economic Literature, American Economic Association, vol. 45(3), pages 686-702, September.
    19. Newell, Richard G. & Pizer, William A., 2004. "Uncertain discount rates in climate policy analysis," Energy Policy, Elsevier, vol. 32(4), pages 519-529, March.
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    Cited by:

    1. Gollier, Christian & Weitzman, Martin L., 2010. "How should the distant future be discounted when discount rates are uncertain?," Economics Letters, Elsevier, vol. 107(3), pages 350-353, June.

    More about this item

    Keywords

    Discount rates; term structure; capital budgeting; interest rate uncertainty; environmental planning;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • Q51 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Valuation of Environmental Effects

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