Abstract
This study argues that diminishing marginal impatience (DMI) as an intuitively plausible behavioural assumption of endogenous time preference has the potential for resolving important issues like the equity premium puzzle. It shows that, while applied to a model in the traditional overlapping generations (OG) framework, DMI is capable of generating assets prices with magnitude and volatility higher than those suggested by standard models with constant marginal impatience (CMI).
Acknowledgements
The authors are grateful to Gregory Huffman and an anonymous referee for useful comments, and would also like to thank the seminar participants of Southern Methodist University for their suggestions.
Notes
1 For a brief survey, see Das (Citation2003).
2 Koopmans (Citation1986, pp. 94–5) questions this assumption of IMI on intuitive grounds and writes to the effect that the opposite assumption of decreasing marginal impatience is likely to be the ‘normal case’. According to Barro and Sala-I-Martin (Citation1995, p. 109), the assumption of IMI is ‘unappealing’ because ‘it is counterintuitive that people would raise their rates of time preference as the level of consumption rises’. For a discussion on intuitive appeal of DMI, see Fisher (Citation1930, p. 72).
3 See Becker and Mulligan (Citation1997) for theoretical justification. Lawrance (Citation1991), Ogaki and Atkeson (Citation1997) and Samwick (Citation1998) provide rich empirical support in favour of DMI. Throughout, the study refers to ‘standard models’ as those with constant (‘exogenous’ to contrast ‘endogenous’) time preference.
4 This article should not be interpreted as an attempt to resolve the equity premium puzzle which requires a more complete and elaborate specification of the model which may involve complexities.
5 See Chakrabarty (Citation2002) and Das (Citation2003) for models that utilize this DMI specification.
6 This capital is alternatively referred to as ‘equity’ or ‘asset’.
7 The qualifier ‘modified’ is used to contrast it with the IES derived from the standard model with CMI.
8 The Matlab program for this simulation exercise is available from the author upon request.
9 High risk aversion required to ‘solve’ the equity premium puzzle implies that the real interest rate should be high for a rich economy. However, as pointed out by Weil (Citation1989) the real interest rate has been scarcely positive over long periods. This is called the ‘risk-free rate puzzle’.
