Expectations-Based Reference-Dependent Life-Cycle Consumption

Abstract

This study incorporates a recent preference specification of expectations-based loss aversion, which has been applied broadly in microeconomics, into a classic macro model to offer a unified explanation for three empirical observations about life-cycle consumption. First, loss aversion explains excess smoothness and sensitivity—that is, the empirical observation that consumption responds to income shocks with a lag. Intuitively, such lagged responses allow the agent to delay painful losses in consumption until his expectations have adjusted. Secondly, the preferences generate a hump-shaped consumption profile. Early in life, consumption is low due to a first-order precautionary-savings motive. However, as uncertainty resolves over time, this motive is dominated by time-inconsistent overconsumption that eventually leads to declining consumption towards the end of life. Thirdly, consumption drops at retirement. Prior to retirement, the agent wants to overconsume his uncertain income before his expectations catch up. Post-retirement, however, income is no longer uncertain, and overconsumption is associated with a sure loss in future consumption. As an empirical contribution, I structurally estimate the preference parameters using life-cycle consumption data. My estimates match those obtained in experiments and other micro studies, and generate the degree of excess smoothness observed in macro consumption data.