Expectations-Based Reference-Dependent Life-Cycle Consumption

Abstract

I incorporate expectations-based reference-dependent preferences into a dynamic stochastic model to explain three major life-cycle consumption facts; the intuitions behind these three implications constitute novel connections between recent advances in behavioral economics and prominent ideas in the macro consumption literature. First, expectations-based loss aversion rationalizes excess smoothness and sensitivity in consumption, the puzzling empirical observation of lagged consumption responses to income shocks. Intuitively, in the event of an adverse shock, the agent delays painful cuts in consumption to allow his reference point to decrease. Second, the preferences generate a hump-shaped consumption profile. Early in life, consumption is low due to a first-order precautionary-savings motive, but as uncertainty resolves, this motive is dominated by time-inconsistent overconsumption, forcing consumption to decline toward the end of life. Third, consumption drops at retirement. When uncertainty is absent, the agent does not overconsume because he dislikes the associated certain loss in future consumption. Additionally, I obtain several new predictions about consumption; compare the preferences with habit formation, hyperbolic discounting, and temptation disutility; and structurally estimate the preference parameters.

Keywords: Expectations-based reference-dependent preferences, life-cycle consumption, excess smoothness, excess sensitivity

JEL Classification: D03, D91