Can Optimism be a Remedy for Present Bias?

Published date01 February 2021
Date01 February 2021
DOIhttp://doi.org/10.1111/jmcb.12726
DOI: 10.1111/jmcb.12726
MINWOOK KANG
LEI SANDY YE
Can Optimism be a Remedy for Present Bias?
Under economies with hyperbolic preferences, vast research has investi-
gated welfare-improving tax policies to resolve capital misallocation issues.
In this paper, we suggests an alternative channel to overcome a form of
this issue associated with consumer’s present bias—optimism, as dened
by overexpectation of future productivity. We show that even though opti-
mism negatively impacts consumers under normal circumstances, a moder-
ate levelof it can be benecial when consumers have hyperbolic preferences.
On the other hand, pessimism always negativelyimpacts consumer welfare.
A steady-state analysis shows that the quantitative impact of optimism on
welfare can be sizable.
Keywords: E7, G3, D2
Keywords: hyperbolic discounting, optimism, present bias, pessimism,
undersavings.
E     sug-
gest that consumers’ discounting functions are approximately hyperbolic rather than
exponential (Ainslie 1992, Loewenstein and Prelec 1992, Angeletos et al. 2001).
Based on such evidence, Strotz (1956), Phelps and Pollak (1968), and Laibson (1996,
1997) developed a time-inconsistent quasi-hyperbolic discounting model. Withtime-
inconsistent preferences, a sequence of selves plays a dynamic game, which re-
sults in suboptimal equilibria. Therefore, governments have incentivesto use various
types of tax policies to curb consumers’ myopic decisions. Under macro-economic
frameworks, consumption tax (Laibson 1997; O’Donoghue and Rabin 2006), savings
An earlier version of this paper was circulated under the title of “Optimism, Present Bias, and the
Macroeconomy.” Weappreciate helpful comments from two anonymous referees and the participants of
the AEI-Five Joint Conference in 2017 at Seoul. The ndings, interpretations, and conclusions expressed
in this paper are entirely those of the authors. They do not necessarily represent the views of the World
Bank, its Executive Directors, or the countries they represent. Kang (corresponding author) acknowledges
the research support from Nanyang Technological University (NTU) AcRF Tier-1Grant (RG62/18). All
errors are our own.
M K is at the Division of Economics, School of Social Sciences, Nanyang Techno-
logical University (E-mail: mwkang@ntu.edu.sg). L S Y is at the World Bank (E-mail:
lye1@worldbank.org).
Received January 31, 2019; and accepted in revised form December 3, 2019.
Journal of Money, Credit and Banking, Vol. 53, No. 1 (February 2021)
© 2020 The Ohio State University
202 :MONEY,CREDIT AND BANKING
subsidy (Krusell, Kuru¸sçu, and Smith 2010, Pavoni and Yazici 2017), and income tax
(Kang 2019) have been proposed as welfare-improving tax policies under settings of
time-inconsistent consumers.1This paper introduces an alternative way to improve
welfare without the use of tax policies. All of the tax policies aforementioned are
revenue-neutral policies—if a subsidy exists, there should be a tax to make the gov-
ernment’s revenueunaffected. These policies incur administrative costs and thus, po-
tentially consumer resistance. On the other hand, this paper proposes producer opti-
mism, which may arise from less costly government actions, as a potential remedy
for consumers’ present bias.
Research evidence suggests that the indirect impact on optimism associated with
government actions (e.g., presidential speech, new policy announcements) affects
the producer’s expectation of future productivity.2Although these actions are not
tax policies, this paper shows that under a hyperbolic economy, they have a similar
impact.
Maintaining positive sentiments in the corporate sector has long been an impor-
tant objective of policymakers. A number of studies in the academic literature have
shown that perceptions on economic activity drive economic outcomes. Theoreti-
cally, overoptimism may help situate the economy on a new equilibrium path under
environments of strong complementarity, such as in Cooper and John (1988). Ro-
dríguez Mora and Schulstad (2007) show for European economies that Gross Na-
tional Product (GNP) announcements that deviate from the actual can impact invest-
ment and economic activity. Similar evidence are shown by Blanchard, Lorenzoni,
and L’Huillier (2017) and Enders, Kleemann, and Mueller (2017). For example, in
monetary policy, policymakers can consider its growth forecasts based on a slightly
more optimistic path of expected future corporate revenue by operating on a baseline
where corporate managers invest in all long-term net present value (NPV) projects,
thereby helping to manage expectations (King, Lu, and Pasten 2008). In scal policy,
policymakers can consider budget forecasts based on a baseline of low political in-
stability and risk, factors that support investment activity (Gulen and Ion 2016, Julio
and Yook 2012).
During economic recessions, government policy announcement and communica-
tion that strongly signal reduced policy uncertainty in the future could be warranted
as well, as evidence has shown that positive sentiments are especially important
1. Research suggests that governments adopt polices to curb consumers’ present bias. See Diamond
and Köszegi (2003) for retirement policy plans, O’Donoghue and Rabin (2006) for commodity taxation
of addictive goods, Krusell, Kuru¸sçu, and Smith (2010) for investment subsidy policies, Guo and Krause
(2015) for nonlinear income taxation without commitment, and Bisin, Lizzeri, and Yariv(2015) for optimal
government policies with time-inconsistent voters. The policies considered in these works are aimed at
increasing consumers’ savings and decreasing their consumption.
2. In our model, optimism is dened by the representative rm as having higher expectation about its
future total factor productivity (TFP) than actual productivity.This overestimation of productivity can be
attributed to producers’ overcondence (see Malmendier and Tate2005) or optimism (see Campbell et al.
2011). An overcondent producer is one who overestimates its own ability in pursuing a project, while
an optimistic producer is one who overestimates the project’s return due to optimism about the macro-
economic environment. Since both overcondence and optimism lead to overestimation of the project
return, our model can be interpreted to reect both types of rms.

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