Can High Discount Rates Increase Capital Accumulation

Xueli Tang | Deakin University

Although experiments often yield estimates for the preferential discount rate on the order of 20-40%, neoclassical models can only replicate macroeconomic observables if the discount rate is on the order of a few percent. Neoclassical models also struggle to match consumption data. Here we show that if households are restricted to Keynesian rules in which consumption is proportional to income during the working life then the optimal irrational behavior will involve a hump-shaped consumption profile that drops o. after retirement, similar to empirical data. Whereas in neoclassical models, the capital-output ratio is always a decreasing function of the discount rate, under restricted optimal irrational behavior the capital-output ratio may be an increasing or decreasing function depending on model parameters. Thus the observed capital-output ratio is easily reconciled with experimental evidence on discount rates.