HH saving and debt

Question 1

What does the discount rate capture (two periods life cycle model)

Answer 1

-If discount rate is positive there is higher weighting associated with earlier periods in the model. Vise versa
-discont rate is specific to each individual, depends on how individual values consumption in future periods relative to current periods.
-discount rate is independent of market discount rate r.

Question 2

Explanations of the retirement savings puzzle

Answer 2

-Life time uncertainty: uncertainty regarding the lifespan of a retiree may lead to more cautious consumption behaviour and a slower depletion in assets.

-Bequests/inheritance: retirees may be motivated to leave inheritance to future generations, therefore prioritising wealth preservation thus reluctance ot consume and reduce down in assets.

-Precautionary saving: refers to setting aside funds for unexpected events, therefore maintain higher levels of saving during retirement, no income therefore precautionary measure.

-Housing equity: housing equity may serve as a source of funds/income to finance consumption during retirement. Evidence shows retirees may be reluctant to dig into equity (inheritance goals, transaction costs, emotional attachment.)

Question 2

Define retirement saving puzzle

Answer 2

-Refers to when retiree’s behaviour contraditcs predictions of standard life cycle models.

-Life cycle hypothesis predicts individuals should save over life during working years and decrease these savings in retirement to smooth lifetime consumption.

-In reality HH’s continue accumulation of assets/maintaining wealth levels after retirement rather than life cycle model predictions.

Question 2

2 period model aka life cycle model (HH saving and debt) assumptions

Answer 2

-Assumes dicounted U model
-Representative HH who earns income in the current and future periods. HH can save or borrow at a (real) interest rate r which is taken as given.
-In period t, first, HH must decide how much to consume/save.
-results from model carry over to models with > 2 periods.
-Exogenous income steams in both periods.
-Saving can be positive or negative (borrowing)
-If save in period 0 gets 1+r * s additonal income in next period, and if borrow have to give up 1+r * s in period 2.

Question 3

2 period model of saving/debt results/insghts

Answer 3

-Household consumption depends on current and future income, therefore forward looking.
-If extra income is anticipated in either periods, HH will want to increase C in both periods, smooth consumption.
-HH smooths consumption relative to income by adjusting saving/borrowing behaviour.
-Non constant discount rates 𝜌
-Time is discounted at a constant rate over time, suggesting time consistent preferences.

Question 4

Implications and results of Quasi hyperbolic discounting model

Answer 4

-explains how time inconsistent preferences can account for the fact peripld change their minds/prefernes depending on when the ‘event occuts’ and how to balance present and the future.

-Dynamically inconsistent model predicts problems of self control such people wanting to quit smoking, do homework yet fail todo so.

Question 5

Assumptions of Quasi hyperbolic discounting model (saving/debt/household intertemporal decision making)

Answer 5

-Behavioural approach to intertemporal decision making allowing bias to be introduced through the explaination of time inconsistent preferences.

-Laibson 1997 preferences can be represented using the following utility function:
𝑈𝑡 = u𝑡 + 𝛽𝛿u𝑡+1 + 𝛽𝛿^2ut+2 + 𝛽𝛿^3ut+3

-Where 𝛽 and 𝛿 belong to the set of all numbers between 0 and 1.

-𝛿 exponentially discounts all future periods whilst 𝛽 uniformly discounts all future periods.

Question 6

Exercise example in quasi hyperbolic discounting model

Answer 6

see flashcard

Question 7

When 𝛽 = 1 and 𝛽 < 1 in the quasi hyperbolic discounting model (intertemporal decision making)

Answer 7

-When 𝛽 = 1, time consistency and the model reduces down to standard eponential discounting.

-When 𝛽 < 1 all outcomes beyond the present get discounted greater than under exponential discounting.

-More weighting is given to current period compared to future, meaning future preferences are current biased. If b < 1, their preferences means when given a choice between small early reward and bigger later reward they will choose earlier (present bias) but then regret it.

Question 8

literatures determinants of HH saving and debt behaviour

Answer 8

Literature provides a range of determinants of HH saving and debt behavioiur: income, interest rates, econ growth, financail literacy, time inconsisten preferences, behavioural bias mental accountng etc.