Short-term planning and the life-cycle consumption puzzle

This paper provides a new explanation for the hump-shaped age- consumption profile observed in household data. Standard life-cycle models are based on an optimization problem that spans the entire life expectancy. Alternatively, we examine the consumption profile of an individual with a shorter planning horizon. The actual consumption profile is the envelope of a continuum of control problems because the agent’s short-term planning horizon continually slides along the time- scale, and the agent is therefore continually re-optimizing. We derive analytical solutions to a deterministic, continuous-time control model with this characteristic and we show that hump-shaped consumption is a feature of the model.