Intertemporal Choice and Legal Constraints

Abstract

We study the effect of legal constraints in an environment in which agents face demand shocks they would like to smooth, but the agents also have weakness of will: their long and short run preferences are misaligned. Some agents are sophisticated - they know they will make inconsistent intertemporal choices - while other agents are naive. The consequent public policy problem is complex. The state apparently should facilitate consumer borrowing, to help agents cushion the effect of shocks, but also should facilitate pre-commitment, to help agents control excessive present-based preferences. We show that naive and sophisticated agents make similar consumption/savings choices, which simplifies the policy problem. We also show that agents with relatively strong present-based preferences who face relatively mild consumption shocks will borrow to finance excessive current consumption. Other agents save appropriately. Legal constraints that severely restrict agents' access to credit thus would be overinclusive. Offering agents access to both a liquid and an illiquid savings vehicle is welfare improving relative to allowing agents complete freedom to borrow or strongly restricting their access to the credit market.