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Lecture 36 Behavioral & Classical Life Cycle Theories

Wealth Accounts

  • To deal with self-control, place funds in accounts off-limits
  • There is a hierarchy…

Most tempting to least accessed accounts

  1. Current assets' Cash on hand, money market
    • Routinely spent each period
    • Marginal propensity to spend = 1.0
  2. Current wealth' \(\to\) Savings, stocks, bonds, mutual funds
    • Designated for saving
  3. Home equity
    • Home equity loans exist… so this category is less sacred now, but households still aim to pay off the mortgage (most succeed)

  4. 'Future income' account

    • Money earned later in life
    • Retirement savings
    • MP(Spend) = 0

  5. These predictions contrast standard economic theory of saving: the life-cycle model

    • says… "Wealth is perfectly fungible"
    • Simplified version
      • \(N\) years to die
      • Interest rate = 0
      • \(W\) be his wealth = her assets + this year's income + future (expected over life) income.
    • Consumption = \(\dfrac{W}{N}\)
    • And any change in wealth \(\Delta W\) \(\implies\) Consumption changes by \(\dfrac{\Delta W}{N}\)

Alternative proposed behavioral life-cycle model
- If money gets transferred to least tempting account, savings increases
- HELP DESIGN GOVERNMENT PROGRAMS

Behavioral Life-Cycle Model

  • Increase long-term savings by moving funds to a less-tempting account
  • Households contributing to retirement savings plans, save more, don't take from other accounts.

Life-Cycle Theory

In any year, consume the amount of you would receive if you owned an annuity which can be purchased by the present value of your wealth, including current income, net assets and future expected income.

The LC model doesn't test out well. Empirical anomalies.

  1. Consumption is sensitive to income. Young and old consume too little. Middle, too much. year-to-year consumption rates are too correlated with income
  2. Forms of wealth don't substitute as LC suggests. Households have low MPC from pension wealth or home equity.

They tried to gaslight their way by giving multiple explanations:
- People aren't rational
- People are hyperrational
- Credit-makers are to blame

Life-Cycle Theory & Fungibility

Focus on the key assumption of fungibility.

Assume that households have a system of mental accounts. This dictates how they behave. Three accounts:
1. Current income \(C\) (MPC = 1)
2. Asset \(A\) (\(0 \lt\) MPC \(\lt 1\))
3. Future income \(F\) (MPC = 0)

Two other modifications to Standard LC:

  1. People are impatient, as if their discount rate1 exceeds interest rate.
  2. Self-Control is difficult
    • One method: irreversible actions
    • Internally enforced rules of thumb
      • Keep two months income in assets account
      • Don't borrow

Household rules
1. don't borrow from \(F\) or \(A\)
- Consumption tracks income (control your consumption)
2. Keep a rainy day account (= fraction of income)
3. Save for retirement in ways that require little self-control

Current Income Account

  • Consumption Tracks Current income

Lifetime Consumption Profiles

  • Hump-shaped age-saving profile.
  • young are below permanent income, borrow to finance
  • Middle aged, save for retirement

  • Old dissave

  • Permanent income savings model \(\implies\) Consumption growth rate depends on interest rate.

  • Consumption growth rates are highly correlated with income growth rates (if interest rates across the world are equalized, and all are equally patient then the long-run growth rate should too equate)

This high correlation is consistent if everyone had flat income and flat consumption.

Predictions of LC Theory
- Fast growing country \(\implies\) Young is richer than old… when the old dies, young replaces and consumes much more \(\implies\) Aggregate consumption increases.
- Less steeply sloped in a rapidly growing country than not
- Shape of consumption profiles should be independent of shape of income profiles ceteris paribus (Not true, gets influenced due to liquidity constraints)

Short-term saving

  • LC theory and PIH suggest that variations in income will be smoothed and consumption \(\propto\) Permanent (and not current) income
  • Annual consumption is empirically sensitive to current income

So, maybe there are two types of consumer:
1. Satisfies PIH
2. Follows the rule of thumb, "spend what you make"

  1. The rate we apply to future consumption ↩