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Income Expectations, Limited Liquidity, and Anomalies in Intertemporal Choice

Thomas Epper

No 1519, Economics Working Paper Series from University of St. Gallen, School of Economics and Political Science

Abstract: Intertemporal choices are a ubiquitous part of our economic lives. Decisions about education, savings and health, all involve tradeoffs between costs and benefits materializing at different points in time. Yet, a large body of experimental evidence questions the descriptive validity of the economic benchmark model (exponential discounted utility) by documenting a series of behavioral patterns allegedly violating its key predictions. Observed discount rates typically lie far beyond market interest rates, tend to decline in time horizon and in outcome magnitude, and seem to be larger for gains than for losses. Hyperbolic preference models resolve these issues only partly: These models accommodate excessive short-run discounting, but fail to predict both outcome dependence and sign dependence. This paper demonstrates that all these “anomalies” are rationalizable without introducing exotic preferences. Instead, an interplay between liquidity constraints and income expectations is able to produce these stylized facts, even if economic agents are fully rational and have a pure rate of time preference close to the market interest rate. Liquidity-constrained agents who dislike fluctuations in the consumption path, but expect their income to rise in the near future prefer to allocate newly available cash inflows at earlier dates than their pure rate of time preference suggests. The assumptions underlying this mechanism are likely to hold for typical participants in laboratory and field experiments. Beyond that, our approach also provides an explanation for a number of phenomena which have remained largely unexplained so far, such as reasons for observed discount rates to increase in time delay, the heterogeneity of discount rates across different commodities and regions, and the co-occurrence of stationarity and dynamic inconsistency. The mechanism is easily distinguished from hyperbolic preferences and optimistic outlook, and its key predictions are retained under bounded rationality and partial asset integration.

Keywords: Time Preferences; Intertemporal Choice; Hyperbolic Discounting; Magnitude Effect; Sign Effect; Stationarity; Time Inconsistency; Expectations; Liquidity Constraints (search for similar items in EconPapers)
JEL-codes: D03 D84 D91 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2015-08
New Economics Papers: this item is included in nep-ger and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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