Life-cycle consumption under social interactions

Abstract

Abstract In this paper we examine how social interactions affect consumption decisions at various levels of aggregation in a life-cycle economy made up of peer groups. For this purpose, we consider two analytically solvable life-cycle models, one under certainty equivalent behavior and one under prudence, and explicitly allow for three different forms of social interactions in peer groups, namely conformism, altruism, and jealousy. We show that whether social interactions have any effects on individuals’ optimal consumption decisions critically depends on intertemporal rather than static considerations. This is true regardless of whether individuals’ preferences are time separable or exhibit habit formation, and whether information within peer groups is homogeneous or disparate. It implies that analyzing the effects of social interactions in static rather than intertemporal settings is likely to be misleading. We also show that social interactions, when coupled with either habit formation or prudence, can significantly strengthen the effects of habit formation or prudence in the direction of resolving two well-known puzzles in the literature on the permanent income hypothesis, namely excess smoothness and excess sensitivity.