SFB 504 discussion paper 99-81

Ralf Rodepeter
Sonderforschungsbereich 504
L 13, 15, D-68131 Mannheim

Joachim Winter
Mannheim Research Institute for the Economics of Aging (MEA)
University of Mannheim, D-68131 Mannheim, Germany

Rules of thumb in life-cycle savings models

We analyze life-cycle savings decisions when households use simple heuristics, or rules of thumb, rather than solve the underlying intertemporal optimization problem. The decision rules we explore are a simple Keynesian rule where consumption follows income; a simple consumption rule where only a fraction of positive income shocks is saved; a rule that corresponds to the permanent income hypothesis; and two rules that have been found in experimental studies. Using these rules, we simulate life-cycle savings decisions numerically and compute the utility losses relative to the backwards solution of the intertemporal optimization problem. Our central finding is that the utility losses induced by rule-of-thumb behavior are relatively low. We conclude that behaving optimally, in the sense of solving an intertemporal optimization model, is not only costly, it is also not much better than using simple heuristics. Our results might also explain why optimization models typically fit the main features of empirical data quite well although optimizing behavior itself is frequently rejected.
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