Title: Consumption ratcheting and loss aversion
Authors: Kyoung Jin Choi - University of Calgary (Canada)
Hyeng Keun Koo - Ajou University (Korea, South)
Junkee Jeon - Kyung Hee University (Korea, South) [presenting]
Abstract: The aim is to investigate the optimal consumption, portfolio selection, and risk attitude of an economic agent who faces partial irreversibility of consumption decisions, formalizing a previously proposed theory. The irreversibility generates consumption ratcheting and dynamic loss aversion. We derive optimal policies and a measure of risk aversion implied by the optimal portfolio in closed form. The optimal consumption policy involves an inaction interval for the consumption-wealth ratio; when the ratio is inside the interval it is optimal not to adjust consumption, and when the ratio is outside the interval, it is optimal to adjust consumption immediately to restore the ratio to the nearest boundary of the interval. In particular, we disentangle the effects of loss aversion from those of risk aversion, and show that loss aversion determines the frequency of consumption adjustments and the shape of the risky share inside the interval, which provides various novel implications for consumption decisions and risk attitudes. We also provide an extension of our model to that with durable or multiple goods.