The Neoclassical Growth Model with Time-Inconsistent Decision Making and Perfect Foresight

Abstract

In this paper, we propose an approach to describe the behavior of naive agents with quasi-hyperbolic discounting in the neoclassical growth model. To study time-inconsistent decision making of an agent who cannot commit to future actions, we introduce the notion of sliding equilibrium and dis- tinguish between pseudo-perfect foresight and perfect foresight. The agent with pseudo-perfect foresight revises both the consumption path and expec- tations about prices; the agent with perfect foresight correctly foresees prices in a sliding equilibrium and is naive only about their time inconsistency. We prove the existence of sliding equilibria for the class of isoelastic utility func- tions and show that generically consumption paths are not the same under quasi-hyperbolic and exponential discounting. Observational equivalence only holds in the well-known cases of a constant interest rate or logarithmic utility. Our results suggest that perfect foresight implies a higher long-run capital stock and consumption level than pseudo-perfect foresight.