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Consumption Paths under Prospect Utility in an Optimal Growth Model

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  • Reto Foellmi
  • Rina Rosenblatt-Wisch
  • Klaus Reiner Schenk-Hopp

Abstract

This paper studies the Cass-Koopmans-Ramsey model of optimal economic growth in the presence of loss aversion and habit formation. The representative agent's preferences for consumption can be gradually varied between the standard constant intertemporal elasticity of substitution (CIES) case and Kahneman and Tversky's prospect utility. We find that the transitional dynamics of optimal consumption paths differ distinctly from the standard model, in particular consumption smoothing is more pronounced. We also show that prospect utility can cause the economy to remain in a steady state with low consumption and low capital.

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  • Reto Foellmi & Rina Rosenblatt-Wisch & Klaus Reiner Schenk-Hopp, 2010. "Consumption Paths under Prospect Utility in an Optimal Growth Model," Diskussionsschriften dp1010, Universitaet Bern, Departement Volkswirtschaft.
    • Handle: RePEc:ube:dpvwib:dp1010
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    1. Rosenblatt-Wisch, Rina, 2008. "Loss aversion in aggregate macroeconomic time series," European Economic Review, Elsevier, vol. 52(7), pages 1140-1159, October.
    2. Edsel L. Beja, 2017. "The Asymmetric Effects of Macroeconomic Performance on Happiness: Evidence for the EU," Intereconomics: Review of European Economic Policy, Springer;ZBW - Leibniz Information Centre for Economics;Centre for European Policy Studies (CEPS), vol. 52(3), pages 184-190, May.
    3. Dominika Czyz & Karolina Safarzynska, 2023. "Catastrophic Damages and the Optimal Carbon Tax Under Loss Aversion," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 85(2), pages 303-340, June.
    4. Jan-Emmanuel De Neve & George Ward & Femke De Keulenaer & Bert Van Landeghem & Georgios Kavetsos & Michael I. Norton, 2018. "The Asymmetric Experience of Positive and Negative Economic Growth: Global Evidence Using Subjective Well-Being Data," The Review of Economics and Statistics, MIT Press, vol. 100(2), pages 362-375, May.
    5. Morhaim, Lisa & Ulus, Ayşegül Yıldız, 2023. "On history-dependent optimization models: A unified framework to analyze models with habits, satiation and optimal growth," Journal of Mathematical Economics, Elsevier, vol. 105(C).
    6. Chi Zhou & Jin Peng & Zhibing Liu & Binwei Dong, 2019. "Optimal incentive contracts under loss aversion and inequity aversion," Fuzzy Optimization and Decision Making, Springer, vol. 18(1), pages 85-102, March.
    7. Clancy, Daragh & Ricci, Lorenzo, 2022. "Economic sentiments and international risk sharing," International Economics, Elsevier, vol. 169(C), pages 208-229.
    8. Curatola, Giuliano, 2016. "Optimal consumption and portfolio choice with loss aversion," SAFE Working Paper Series 130, Leibniz Institute for Financial Research SAFE.
    9. Daragh Clancy & Lorenzo Ricci, 2019. "Loss aversion, economic sentiments and international consumption smoothing," Working Papers 35, European Stability Mechanism.
    10. Keith Blackburn & David Chivers, 2015. "Fearing the worst: the importance of uncertainty for inequality," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 60(2), pages 345-370, October.
    11. Foellmi, Reto & Jaeggi, Adrian & Rosenblatt-Wisch, Rina, 2019. "Loss aversion at the aggregate level across countries and its relation to economic fundamentals," Journal of Macroeconomics, Elsevier, vol. 61(C), pages 1-1.
    12. Teglio, Andrea & Catalano, Michele & Petrovic, Marko, 2014. "Myopic households on a stable path: the neoclassical growth model with rule-based expectations," MPRA Paper 120253, University Library of Munich, Germany.
    13. Curatola, Giuliano, 2017. "Optimal portfolio choice with loss aversion over consumption," The Quarterly Review of Economics and Finance, Elsevier, vol. 66(C), pages 345-358.
    14. Li, Meng, 2023. "Loss aversion and inefficient general equilibrium over the business cycle," Economic Modelling, Elsevier, vol. 118(C).
    15. Lena Dr䧥r & Jan-Oliver Menz & Ulrich Fritsche, 2014. "Perceived inflation under loss aversion," Applied Economics, Taylor & Francis Journals, vol. 46(3), pages 282-293, January.
    16. Curatola, Giuliano, 2015. "Loss aversion, habit formation and the term structures of equity and interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 53(C), pages 103-122.

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    More about this item

    Keywords

    Ramsey growth model; prospect theory; loss aversion; optimal consumption;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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