Time Dependent Preferences in Macroeconomics

TimeDependentPreferencesinMacroeconomics¤TobiasKleinyFebruary2003AbstractThispaperdealswithhyperbolicdiscountinginamacrocontext.Timeconsistencyisdiscussedintermsofrationalbehaviorandratio-nalexpectations.Thetheoryisappliedtotheintertemporalconsump-tiondecisioninordertoexplainundersavinginaneconomy.Moreover,possibleimplicationsonpolicymakers’decisionsonreformsandbud-getdeficitsareevinced.Finally,theRicardianequivalencetheoremisshowntoheavilyrelyontheassumptionoftimeconsistentchoice.JournalofEconomicLiteratureClassificationNumbers:A12,B41,E21,E61,E62,H31,H62.KeyWords:Hyperbolicdiscounting,timeconsistency,preferences,rational-ity,rationalexpectations,undersaving,reforms,budgetdeficits,Ricardianequivalence.¤IamexceedinglygratefultoMatthewRabinwhotaughtthewonderfulcourse“Psy-chologyandEconomics”inthespringterm2002attheUniversityofCalifornia,Berkeley.IowehimmostofwhatIknowaboutbehavioraleconomics.Actually,Iwanttothankhimformessingupaproblemsetandthereforeaskingustoinventourowntimeinconsistencyproblem.Someoftheideasofthispapercameintomymindwhilecompletingthistask.IamalsoverygratefultoStefanieBrilon,ThomasGall,OssipH¨uhnerbein,IngolfSchwarz,andespeciallyUlrichSchlieperforusefuldiscussionsandcommentsonearlierversionsofthispaper.Finally,IwouldliketothankDanielaKotullaforsuggestingtothinkabouttheRicardianequivalencetheoreminmyframework.yUniversityofMannheim,DepartmentofEconomics,68131Mannheim,Germany.E-Mail:[e-mail].1TimeDependentPreferencesinMacroeconomics2“...butyoumustbindmehardandfast,sothatIcannotstirfromthespotwhereyouwillstandme...andifIbegyoutoreleaseme,youmusttightenandaddtomybonds.”–TheOdyssey.1IntroductionThisquoteintroducesStrotz’s(1956)articleentitled“MyopiaandIn-consistencyinDynamicUtilityMaximization”thathasbecomeaclassicamongbehavioraleconomists.Itillustratesthatdecisionmakersaresome-timesfacedtothedilemmathattoday’soptimalplanforthefuturecannotberealizedinthefuture.Inclassicaleconomictheory,tothecontrary,weusuallyassumethatchoiceovertimeistimeconsistentandtherefore,utilitymaximizationyields,forexample,therightsavingsdecisionwhenweab-stractfromsecondordereffectssuchasimplicationsongrowthandwhenweassumeperfectmarkets.Theexistenceofavarietyofsubsidiesandtaxadvantagesthataremeanttoforwardsavings,ontheotherhand,mightbeanindicationfortimeinconsistentbehaviortobeanissueineverydaylife.YetanotherargumentismadebyAkerlof(2002).InhisNobellecture,hepointsoutthat“akeytheoreticalinnovationpermittingsystematicanalysisoftime-inconsistentbehavioristherecognitionthatindividualsmaymaxi-mizeautilityfunctionthatisdivorcedfromtherepresenting‘truewelfare.’Oncethisdistinctionisaccepted,‘savingtoolittle’becomesameaningfulconcept.(page423)”Inthispaper,weshallfirstbrieflyreviewtheideasbehindtheliteratureondynamicinconsistency.Dynamicinconsistencymeansthatoncewere-optimizeinafutureperiod,wechooseanalternativeeventhoughweplannedtochoosedifferently.Itisdrivenbypreferencesthatchangeovertime.1Inanenvironmentinwhichpreferencechangesarepredictablebythedecisionmaker,wecandistinguishatleasttworationalityconcepts:naiviteandsophistication.Naivitearisesifthedecisionmakerdoesnottakeintoaccountthatherpreferencesaresubjecttochangeinthefuture.Therefore,today’soptimalplansforthefuturewillnotcoincidewithheractualbehavior.Incontrasttonaiveindividuals,wewillinterpretsophisticatesaspossesingrationalexpectationsinthesenseofMuth(1960,1961).Thismeansthattheytakeintoaccounthowtheywillbehaveinthefuture.Wewillfirstfocusonthesavingsdecisionwhichwillalsoserveasanexample.Then,wewillgiveinstitutionstheinterpretationofso-calledcommitmentdevicesandmake1IncontrasttothatGulandPesendorfer(2001,forthcoming)considertimeconsistentpreferencesincorporatingtemptationandadesireforcommitment.TimeDependentPreferencesinMacroeconomics3anattempttoevaluatewhetherundersavingisharmfulornot.Moreover,implicationsoftimedependentpreferencesonthepoliticalprocesssuchasonreformsandbudgetdeficitsarediscussed.Inparticular,wefirstgiveanexplanationforthephenomenonthatdesirablereformsareoftenpostponedandtheninterpretbudgetdeficitsasacommitmentdevice.Finally,theRicardianequivalencetheoremisshowntoheavilyrelyontheassumptionoftimeconsistentchoice.InSection2,timedependentpreferencesareintroduced.Itisshownthatitdependsonboththefunctionalformoftheutilityfunctionandtheratio-nalityconceptwhethertimeconsistentbehaviorisachievableornot.Section3brieflydiscussesmeaningfulwelfareconceptsifpreferencesaresubjecttochangeovertime.Then,weaddressthequestionwhyoutcomesofthepo-liticalprocessthatareobviouslyundesirableareobservedanddiscusstheimplicitassumptionsoftheRicardianequivalencetheorem.Section4con-cludes.2ModelingTimeInconsistentBehaviorThissectioncoversthebasicconceptsthatweshallapplythereafter.First,rationalpreferences,rationality,andrationalbehaviorisformallydefined.Then,weconsidertwospecificformulationsofso-calledpresentbiasedpref-erences.Itisshownthatactualbehaviordependsontherationalityconceptthatisused.Throughoutthissection,thehouseholds’savingsdecisionservesasanexample.22.1OntheConceptofRation