Can Overconfidence Explain the Consumption Hump?: A General Equilibrium Inquiry

Abstract

The standard neoclassical life-cycle model predicts that individual consumption should either increase, remain constant or fall monotonically depending on whether the market rate of return on savings is greater than, equal to or less than the discount rate. However, empirical evidence suggests that even after controlling for economic growth and family size, household consumption exhibits a robust hump at around age 45-55, with the ratio of peak consumption to consumption when entering the workforce greater than 1.1. This paper extends the "overconfidence" explanation (Caliendo and Huang, 2008) of this macroeconomic puzzle to a calibrated general equilibrium environment. The main finding is that although it is possible to identify parameter values under which overconfidence alone generates life-cycle consumption profiles and macro-indicators consistent with U.S. experience, quite extreme assumptions about both the magnitude and distribution of overconfidence in the population are generally required to obtain them.

Keywords: overconfidence, bounded rationality, life-cycle, consumption, hump-shape

JEL Classification: D58, D91, E21