Rewards from Savings Debt Aversion and Mental Accounts∗

This paper analyzes the process behind the formation of mental accounts by an individual. The model is inspired by the Behavioral Life-Cycle Hypothesis of Shefrin and Thaler. It extends the traditional utility function to accomodate debt aversion. Then the model produces a consumption function with differentiated marginal propensities to consume out of different forms of wealth, which is the main prediction of mental accounting. A class of quadratic utility functions is used that provides closed form solutions of the consumption function. Mental accounting then arise when the marginal utility of consumption increases with income and the individual is averse to debt. The assumptions are in line with the work of Thaler and Prelec and Loewenstein. Next, a specific utility function is chosen to demonstrate that the model explains empirical puzzles of individual and aggregate consumption. At the microeconomic level, the consumption of the behavioral consumer tracks income, and it drops at the time of retirement. At the macroeconomic level, the consumption of the behavioral representative agent is not orthogonal to past income innovations, and its volatility is smaller than the volatility of income. Finally, when debt aversion is coupled with either precautionary savings or liquidity constraints, the individual still exhibits a strong tendency to finance consumption mainly about of current income. ∗I would like to thank Robert Shiller for all his guidence at all steps of this project. The paper was also benefited from comments by Stefan Krieger, Alexander Michaelides, Ben Polak, Ricky Lam, David Laibson, Ioannis Serafides, and Amil Dasgupt. Finally, special thanks goes to the participants of the Prospectus Workshop in Macroeconomics at the Department of Economics at Yale University. All the remaining errors are mine. †E-mail: [email protected]. Mail: University of Notre Dame, Department of Finance, 102 Mendoza College of Business, Notre Dame, IN 46556. Telephone: (574) 631-9322.