Life-cycle consumption under social interactions

In this paper we examine how social interactions affect consumption decisio ns at various levels of aggregation in a life-cycle economy made up of peer groups. For this purpose, we consider two analytically solvable life-cycle models, one under certainty equivalent behavior and one under prudence, an d explicitly allow for three different forms of social interactions in peer groups, namely conformism, altruism, and jealousy. We show that whether so cial interactions have any effects on individuals' optimal consumption deci sions critically depends on intertemporal rather than static considerations . This is true regardless of whether individuals' preferences are time sepa rable or exhibit habit formation, and whether information within peer group s is homogeneous or disparate. It implies that analyzing the effects of soc ial interactions in static rather than intertemporal settings is likely to be misleading. We also show that social interactions, when coupled with eit her habit formation or prudence, can significantly strengthen the effects o f habit formation or prudence in the direction of resolving two well-known puzzles in the literature on the permanent income hypothesis, namely excess smoothness and excess sensitivity. (C) 2001 Elsevier Science B.V. All righ ts reserved. JEL classification: D91; E21.