Macroeconomic implications of dynamically inconsistent preferences

Abstract

Despite the widespread use of models of intertemporal choices in economics, previous studies have assumed that intertemporal preferences are dynamically consistent. This paper provides a fresh perspective on propagation mechanisms of a typical macroeconomic shock in a model with dynamically inconsistent preferences. To this end, I develop a prototypical neoclassical model that features dynamically inconsistent preferences to explore dynamic responses of key macro-aggregates, discounted cumulative effects and some characteristics of aggregate fluctuations in response to a technology shock. The main findings reveal that (a) consumption and investment in the proposed model show a larger increase than those in a standard neoclassical model; (b) unlike the standard model, the proposed model yields a short-run decline in labor, which is corroborated by previous studies; (c) all of these dynamic responses in the proposed model deliver smaller cumulative output effects; (d) the proposed model does a reasonably good job of matching key characteristics of aggregate fluctuations with the counterparts observed in the postwar U.S. data. The present-bias and sophistication effects are the linchpin of these main results. Various analyses on a set of different parameter values are also discussed.