Chapter 2 Shattered Plans ? Save More . On Reference - dependence and Liquidity Constraints

This chapter analyzes reference-dependent consumption plans in a context of imperfect financial markets. Applications of prospect theory suggest that utility depends not only on consumption itself but also on gains and losses relative to prior consumption plans. By loss aversion, consumers prefer not to consume below planned levels, and by diminishing sensitivity, they prefer to take a sure loss within one period. I analyze how these reference-dependent preferences interact with financial market imperfections, modeled as a liquidity constraint. Consumers without access to credit might have to give up plans regarding early consumption even though future plans are still feasible. To carry through these future plans, they may well decide to take the full loss in early periods and save more than a reference-independent consumer would do. This anomaly sharply contrasts findings from models without liquidity constraints. One should hence take into account the presence of financial market imperfections when applying prospect theory.