PhD Lunch Seminars Amsterdam

Berber Kramer

This paper concerns savings behavior in a context of financial market imperfections under prospect theory. The analysis focuses on three of its key aspects: reference dependence, loss aversion and diminishing sensitivity. Studies from developed countries provide empirical support for such preferences, but evidence from countries without well-functioning financial markets is limited. I therefore investigate the implications of a liquidity constraint for savings under prospect theory. Peculiar patterns arise. First, savings are not determined by permanent income or wealth on hand, but by their distance to a reference point. Second, savings respond to losses and gains asymmetrically. Third, liquidity constrained consumers with a preference to borrow may save strictly positive amounts. Fourth, the savings function is in many cases neither monotonic nor continuous. Finally, risk is not necessarily associated with precautionary savings. Savings hence deviate qualitatively in many respects from what concave utility models predict (e.g. Deaton, 1991). These findings suggest a need for empirical research on the behavioral foundations of savings in developing countries.