Exponential‐growth Bias in Experimental Consumption Decisions

Abstract

Exponential‐growth bias (EGB) is the tendency to neglect the power of compounding interest, which has been found to be widespread in the population. A person with EGB will misperceive the intertemporal budget constraint, overestimating lifetime wealth and underestimating the differences in the cost of consumption across periods. We test five comparative static predictions implied by EGB: (1) compound interest will increase consumption when the elasticity of intertemporal substitution is greater than 1; (2) higher interest rates lead to more compounding and hence increase consumption; (3) budget‐neutral delays in income will increase consumption; (4) the person will exhibit a form of dynamic inconsistency that depends solely on the current account balance and is independent of time preferences; and (5) framing the frequency of interest in shorter units increases consumption. We test these predictions using an induced‐value consumption–savings experiment in the laboratory, and find evidence in support of all predictions against the rational benchmark. We consider rules of thumb as alternative hypotheses and find that they cannot explain the results, although they contribute to some findings.