Time Non-separable Preferences Research Articles

A Behavioral Foundation of Satiation and Habituation

Tastes change over time. People’s tastes are distorted through two channels: satiation formation and habit formation. In this paper, we develop a theoretical foundation of satiation and habituation by an axiomatic approach. Our theory is based on a hierarchy of preference conditions called compensation independence. The behavioral assumption underlying the preference conditions are the psychological compensation of human beings. I flesh out an axiomatic system for general models of satiation and habit formation, which contains many functional forms in the literature as special cases. Moreover, I advance the axiomatization to accommodate the linear representations of satiation and habit formation that are prevailing in the literature. This paper contributes to the birth of a new generation of the behavioral foundation for modeling satiation and habit formation, which might improve on the current state of the art in understanding people’s tastes over time and preferences. Theoretically, this study contributes to the vein of time-nonseparable preferences.

Are preferences for work reference dependent or time nonseparable? New experimental evidence

Tests of labor supply models often rely on wages. However, wage variation alone generally cannot disentangle the classical time separable model and its extensions: reference dependent preferences (income targeting) and time nonseparable preferences (disutility spillovers; timing-specific preferences). We set up a novel laboratory experiment in which individuals choose their working time. We vary, independently, wages, historical income paths, and cumulative past work. We also vary the timing of experimental sessions. Statistical tests and stochastic revealed preference methods cannot reject the classical model in favor of income targeting or disutility spillovers, but the data suggest that labor supply varies by time-of-the-day.

A New General Equilibrium Welfare Measure, with Application to Labor Income Taxes

Abstract In this paper we extend the Hicksian compensating variation welfare measure in two directions. First, we adjust the size of the compensating variation in order to account for the fact that the compensating transfers will result in changes in output, as well as in prices, because labor and, in dynamic models, capital will adjust in response to these transfers. Second, we extend the measure to a dynamic setting with possibly time non-separable preferences. We find that these considerations become more significant for the welfare cost of higher labor income taxes as one moves from static to dynamic models, to models with time non-separable preferences, and finally to models with uncertainty.

Call it a Day: History Dependent Stopping Behavior

In this paper, we provide evidence of history-dependent stopping behavior. Using data from an online chess platform, we estimate a dynamic discrete choice model in which an agent may have time non-separable preferences over the stochastic outcomes of their actions. We show that the agent’s decisions cannot be reconciled in a model with time separable preferences and that there is substantial heterogeneity in preferences across players. In particular, there are two types of people: those who get discouraged by a loss and stop, and others, who get encouraged by failure and keep playing until a win. We show how to leverage the information about an agent’s type in market design to achieve various welfare goals. A counterfactual analysis demonstrates that a matching algorithm that incorporates stopping behavior can significantly increase the length of play.

Call it a Day: History Dependent Stopping Behavior

In this paper, we provide evidence of history-dependent stopping behavior. Using data from an online chess platform, we estimate a dynamic discrete choice model in which an agent may have time non-separable preferences over the stochastic outcomes of their actions. We show that the agent’s decisions cannot be reconciled in a model with time separable preferences and that there is substantial heterogeneity in preferences across players. In particular, there are two types of people: those who get discouraged by a loss and stop, and others, who get encouraged by failure and keep playing until a win. We show how to leverage the information about an agent’s type in market design to achieve various welfare goals. A counterfactual analysis demonstrates that a matching algorithm that incorporates stopping behavior can significantly increase the length of play.

Option pricing under regime-switching models: Novel approaches removing path-dependence

A well-known approach for the pricing of options under regime-switching models is to use the regime-switching Esscher transform (also called regime-switching mean-correcting martingale measure) to obtain risk-neutrality. One way to handle regime unobservability consists in using regime probabilities that are filtered under this risk-neutral measure to compute risk-neutral expected payoffs. The current paper shows that this natural approach creates path-dependence issues within option price dynamics. Indeed, since the underlying asset price can be embedded in a Markov process under the physical measure even when regimes are unobservable, such path-dependence behavior of vanilla option prices is puzzling and may entail non-trivial theoretical features (e.g., time non-separable preferences) in a way that is difficult to characterize. This work develops novel and intuitive risk-neutral measures that can incorporate regime risk-aversion in a simple fashion and which do not lead to such path-dependence side effects. Numerical schemes either based on dynamic programming or Monte-Carlo simulations to compute option prices under the novel risk-neutral dynamics are presented.

On the size of the government spending multiplier in the euro area

This article addresses the existence of a wide range of estimated government spending multipliers in a dynamic stochastic general equilibrium model of the euro area. Our estimation results and counterfactual exercises provide evidence that omitting the interactions of key ingredients at the estimation stage (such as Edgeworth complementarity/subtitutability between private consumption and government expenditures, endogenous government spending policy and general time nonseparable preferences) paves the way for potentially large biases. We argue that uncertainty on the quantitative assessments of fiscal programmes could partly originate from these biases.

Evidence that Risk Adjustment is Unnecessary in Estimates of the User Cost of Money

Investors value the special attributes of monetary assets (e.g., exchangeability, liquidity, and safety) and pay a premium for holding them in the form of a lower return rate. The user cost of holding monetary assets can be measured approximately by the difference between the returns on illiquid risky assets and those of safer liquid assets. A more appropriate measure should adjust this difference by the differential risk of the assets in question. We investigate the impact that time non-separable preferences has on the estimation of the risk-adjusted user cost of money. Using U.K. data from 1965Q1 to 2011Q1, we estimate a habit-based asset pricing model with money in the utility function and find that the risk adjustment for risky monetary assets is negligible. Thus, researchers can dispense with risk adjusting the user cost of money in constructing monetary aggregate indexes.

Evidence for state and time nonseparable preferences: the case of Finland

Preferential modifications to the standard state and time separable power utility are studied for the Finnish equity and bond returns. The reported ambivalence of the high equity premium and low Sharpe ratio makes the Finnish market an important case study. The estimations of the Epstein and Zin (1991) recursive utility and the Campbell and Cochrane (1999) habit formation preferences show that Finnish risk premia are time-varying across samples. Moreover, the results demonstrate that stronger time preferences improve the explanation of asset returns for the modified preferences more so than assuming tighter time preference and higher risk aversion (RA). We conclude that the Campbell–Cochrane-based pricing kernel outperforms the competing models in generating plausible model parameters and suppressing specification errors. The study supports the US evidence relative to the conclusions drawn from the European economies in comparable studies.

Evaluating monetary policy under preferences with zero wealth effect: A Bayesian approach

Both real and monetary macro models have parallely exploited the potential for various preferences in accounting for empirical facts. This paper brings the two literatures together by estimating time non-separable preferences with habit formation in consumption that nests several commonly used preferences. In the absence of wealth effects and external habits, these preferences fail to generate observed inflation inertia and output persistence after a monetary policy shock. Furthermore, the data strongly rejects these preferences in favor of preferences with external habits. An alternative solution is to include habit adjusted intermediate wealth effect preferences which are able to simultaneously generate sluggish responses of the variables to a monetary policy shock and fit the data better.

Optimal Capital Taxation for Time-Nonseparable Preferences

This paper studies the effect of habit formation on optimal capital taxes in a dynamic Mirrleesian model. We make three distinct contributions. First, we decompose intertemporal wedges (implicit capital taxes) for general time-nonseparable preferences into a wealth effect, a complementarity effect, and a future incentive effect. Second, we provide conditions under which intertemporal wedges are positive. Third, we derive a recursive formulation of constrained efficient allocations and evaluate the quantitative impact of habit formation. In a model parameterized to the U.S. economy, habit formation reduces average intertemporal wedges by about 40 percent compared to the time-separable case. Moreover, intertemporal wedges are close to zero for the largest part of the working life.

DYNAMIC EFFECTS OF OIL PRICE SHOCKS AND THEIR IMPACT ON THE CURRENT ACCOUNT

We study the dynamic effects of an oil price shock on key economic variables and on the current account of a small open economy. We introduce time-nonseparable preferences into a standard model of a small open economy, where imported oil is used both as an intermediate input in production and as a consumption good. Using a plausible calibration of the model, we show that the changes in output and employment are quite small, and that the current account exhibits the J-curve property, both being in line with recent empirical evidence. After an oil price increase, employment falls and the current account first deteriorates. Over time, with gradually falling expenditures, the trade balance improves sufficiently to turn the current account into a surplus. The model thus provides a plausible explanation of recent empirical findings.

International business cycles with complete markets

Kehoe and Perri (2002) show that a two-country business cycle model with endogenously incomplete markets helps to resolve the “international comovement puzzle” (Baxter, 1995) and the “quantity anomaly” (Backus et al., 1992, 1995). We claim that a similar performance can be achieved without resorting to market incompleteness. We show that a model with complete markets driven by productivity shocks alone can account for the “international comovement puzzle”. Our model features time nonseparable preferences that allow arbitrarily small wealth effects on labor supply. It matches the data by predicting (i) positive cross-country correlations of investment and hours worked; (ii) realistic cross-country correlations of consumption. It reduces the gap between international correlations of output and consumption, but fails to change their order. Unlike models with restricted international markets, ours show little sensitivity to the parameterization of the forcing process.

Foundations of Intrinsic Habit Formation

We provide theoretical foundations for several common (nested) representations of intrinsic linear habit formation. Our axiomatization introduces an intertemporal theory of weaning a decision-maker from her habits using the device of compensation. We clarify differences across specifications of the model, provide measures of habit-forming tendencies, and suggest methods for axiomatizing time-nonseparable preferences.

Dynamic Effects of Oil Price Shocks and Their Impact on the Current Account

Our objective is to study the dynamic effects of an oil price shock on economic key variables and on the current account of a small open economy. To do this, we introduce time non-separable preferences in a standard model of a small open economy, where labor supply is endogenous and imported oil is used both as an intermediate input in production and as a consumption good. Using a plausible calibration of the model, we show that the changes in output and employment are quite small, and that the current account exhibits the J-curve property, both being in line with recent empirical evidence. After an oil price increase, the current account first deteriorates, and after some time it turns into surplus. We explain this non-monotonic behavior with agents' reluctance to change their consumption expenditures, resulting in an initial trade balance deficit which causes the current account to deteriorate. Over time, with gradually falling expenditures, the trade balance improves suffciently to turn the current account into surplus. The model thus provides a plausible explanation of recent empirical findings.

ANOTHER VIEW OF THE J-CURVE

Most of empirical studies find evidence of the J-Curve, but recent results cast doubt over its standard explanation. By addressing the countercyclicality of the current account and its dynamic link with the terms of trade, this paper revisits the J-Curve phenomenon using a two-good dynamic optimizing small open economy model allowing for a habit-forming behavior and capital adjustment costs. While the nonmonotonic adjustment of the current account relies on the degree of habit persistence in consumption and the magnitude of capital installation costs after an unanticipated terms of trade worsening, we show that the sizes of the long-run intertemporal elasticity of substitution under time nonseparable preferences and the import content of real consumption and investment matter as well after a temporary perturbation. As a consequence of an intertemporal speculation effect and an inertia effect, the small country reaches the long-term equilibrium with higher foreign assets after a short-lived terms of trade worsening.

Consumption externalities, production externalities, and efficient capital accumulation under time non-separable preferences

The effects of consumption and production externalities on economic performance under time non-separable preferences are examined both theoretically and numerically. We show that a consumption externality alone has long-run distortionary effects if and only if labor is supplied elastically. With fixed labor supply, it has only transitional distortionary effects. Production externalities always generate long-run distortions, irrespective of labor supply. The optimal tax structure to correct for the distortions is characterized. We compare the implications of this model with those obtained when the consumption externality is contemporaneous. While some of the long-run effects are robust, there are also important qualitative and quantitative differences, particularly along transitional paths.

Mean reversion in asset returns and time non-separable preferences

Time non-separable preferences are used in combination with various specifications of the endowment process to calibrate the Capital Asset Pricing Model (CAPM). Time non-separability is caused either by habit persistence or durability. It is demonstrated that the model can indeed produce the amount of mean reversion detected in historical returns. Specifically, habit persistence is required to match negative autocorrelation of annual asset returns and durability is needed to replicate positive autocorrelation detected in monthly asset returns. In addition, the CAPM with habit persistence can predict negative expected returns when calibrated to monthly data.

An empirical investigation of the consumption based Capital Asset Pricing Model using a modified variance-ratio test

A chi-square statistic is constructed that compares variance ratios and mean simple returns from data with those implied by an asset pricing model. The statistic is applied to the Consumption based Capital Asset Pricing Model with time non-separable preferences. It favors habit persistence for annual data, time-separability for quarterly data, and durability for monthly data, respectively. Introduction of time non-separability yields only a marginal improvement. The power of the test is high when alternative hypotheses are formed by varying the relative risk aversion coefficient. It is lower for alternative hypotheses generated by varying the time non-separability parameter, especially for durability.

Substitution, risk aversion, taste shocks and equity premia

This paper investigates the testable restrictions on the time-series behavior of equity premia implied by a representative agent model whose state- and time-non separable preferences are subject to taste shocks. The model nests state- and time-separable preferences with and without taste shocks as special cases. Empirically, the linearized Euler equations are estimated through Kalman filtering, allowing for conditional heteroscedasticity via a common factor GARCH process. With or without conditional heteroscedasticity, (i) the hypothesis that preferences are separable cannot be rejected, (ii) taste shocks influences are statistically significant, and (iii) taste shocks yield reasonable estimates of the coefficient of relative risk aversion. This last result occurs because taste shocks reproduce the large observed equity premium by shifting weight away from consumption risk in favor to taste risk.