When expectations become aspirations: reference-dependent preferences and liquidity constraints

Berber Kramer

Economic Theory, 2016, vol. 61, issue 4, No 4, 685-721

Abstract: Abstract A large body of literature suggests that consumers derive utility from gains and losses relative to a reference point. This paper shows that such reference dependence can affect savings in opposite directions depending on whether people face liquidity constraints. Existing models for wealth and intertemporal choice predict that reference dependence reduces savings, but these models abstract from liquidity constraints. Introducing a liquidity constraint, I find that reference dependence can increase optimal savings for people without access to credit. Ex post, after reference points have been formed, liquidity constraints force consumers to take part of an income loss in early periods, inducing those who are reference dependent to concentrate the full loss in early periods and save in order to eliminate future losses. Further, anticipating a liquidity constraint raises the expected level of future consumption and thus the expectations-based reference point for future periods, creating an ex-ante savings motive. These findings underscore that it is important to account for financial market imperfections when applying or testing reference-dependent models in low-income settings, and potentially explain heterogeneity in how much the poor save when facing binding liquidity constraints.

Keywords: Loss aversion; Imperfect financial markets; Intertemporal choice (search for similar items in EconPapers)
JEL-codes: D14 D81 D91 O12 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (9)

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DOI: 10.1007/s00199-015-0949-9

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