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Lecture 37 Budgeting & Choice Bracketing

Wealth Account

Is Wealth Fungible?

What affects household's saving?

  • Life-cycle model: makes predictions about which variables have effect on saving and which don't.
  • Composition of wealth shouldn't have any effect on savings
  • Most households wealth constituency:
    • Future income
    • Pension wealth
    • Home equity
    • (should be nearly perfect substitutes)

Pension Wealth

  • \(H_{0}: \dfrac{\text{change in discretionary savings}}{\text{change in pension wealth}} = -1.0\)
  • But research suggests that it was positive!
  • Adding a dollar of pension wealth slightly increased other savings.

Housing Wealth

  • Life-cycle theory assumes, home equity is fungible.
  • Young household
    • accumulate liquid asset
    • make down payment
    • buy house
    • accumulate assets again
  • So expectation is less savings in other assets, as home equity is built by paying off mortgage
  • Empirically: MPC from housing wealth is insignificant (or small)
    • Life-cycle anomaly: elderly don't dissave fast enough (young couples spend like crazy)
  • Reluctance to spend home is voluntary by homeowners over 65

Emotional Accounting

  • When people acquired increased wealth under unpleasant circumstances
    • e.g. contentious life insurance settlement
    • e.g. suit for a wrongful death of a child
  • Here, gain = negative affective tag

Two strategies:
- Hedonic avoidance: people avoid spending on enjoyments (guilt)
- laundering: virtuous or utilitarian goods, education, donations to charity

  • moral cleansing

  • some trade-offs are regarded as taboo

    • friendship vs improved living conditions
    • don't put a monetary value

  • Reluctance to sell a ring bequeathed to them by a parent

Denomination Effect

  • Will spend ten ₹50 notes, but not one ₹500 note. Reluctance
  • People don't like 'breaking' large denomination bills
    • Significant decrease in wealth
  • Prefer large denomination as a self-control device

Prefer spending used or worn notes, rather than crisp new ones. Lack of fungibility from disgust.

So far: Violations of fungibility by budgeting process or location of fund

Now look at source of income:

Budgeting - Income Account

  • Winning of a football pool: Frivolous \(\to\) eating out
  • Income from tax refund is serious \(\to\) paying the bills

Match the seriousness of source (jacket pocket) with the use.

Income Accounting

  • Labeling effects
    • Child allowance from govt \(\to\) spend on child's clothing only
  • No firm should actually ever pay dividend (because they are taxed) instead they should prefer share repurchases.

But why pay dividends then?
- Regular cash payment provides simple self-control rule: "Spend dividends, leave principal" (dividends = allowance)
- If not, then stockholders won't receive anything and would have to dip into the capital periodically.

  • 'mailbox effect': gain on paper will not get spent. But if the check is mailed, it has a tendency to be spent. So, capital gains will not affect consumption but would do if they are realized.

Sources of Income, Bonuses & Windfall

MPC of windfall gains depend on the size of the gains.

  • Small gains, relative to income = current income & spent
  • Larger gains = assets account, MPC is lower

Source of change of wealth also matters.

  • Unrealized capital gains = changes in assets account (even if they are small)
  • Sale of a security = income
  • MPS = 1 for capital gains in stock market.
  • Cash receipts = assets (if large inflow and not considered regular income)

Interesting cases
- Bonus = fully anticipated but lumpy payment
- Two professors
- John: 55k (monthly)
- Joan: 45k (base, monthly) + 10k (summer months only)
- Standard theory: they have equal MPS
- Joan's regular income is lower = gear lifestyle to a lower level
- Summer salary = assets account, lower MPC
- Japan researchers
- MPC (regular income) = 0.685
- MPC (bonus income) = 0.437