Framing Interest: Misperceptions of Consumption and Savings

Abstract

Exponential-growth bias (EGB) is the tendency to neglect the power of compounding inter- est. 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 four comparative static predictions implied by EGB: (1) compound interest will increase consumption, (2) budget-neutral delays in income will increase consumption, (3) the person will exhibit a form of dynamic inconsistency that depends solely on the current account balance and is independent of time preferences, and (4) framing the frequency of interest in shorter units increases consumption. We test these predictions using an induced-value consumption-savings experiment in the lab, and find evidence in support of all predictions against the rational bench- mark. People may use rules of thumb when making consumption-savings decisions. We consider three rules of thumb as alternative hypotheses and find that they cannot explain the results.