Monday, June 18, 2012

Planning for the future

Good morning!! The topic of today's discussion is planning for the future, a trade particularly important in times of crisis. Traditionally in economics, we are referring to the notion of retrospective memory, that is, the ability of the individual to recall past information and act accordingly. Today we will talk about prospective memory or recalling to act on a future event.

The problem with taking decisions that will be implemented in the future is that people do not possess the full information on the state of affairs at the time of action. A potential car buyer for example might enter into a lease agreement for four years, but end up loosing his job in two years. At that time it may be impossible to continue making payments and most likely he will end up loosing the car.

The problem with prospective memory, is that we tend to overestimate our future potential when taking a decision today. Have you ever found yourself making a promise that you couldn't keep? That is because at the time that the promise was made, you overestimated your chances of fulfilling the promise. Very simply, this is the economic theory behind prospective memory.

Let us combine this with the simple assumption in the circular flow of income model in macroeconomics. Households can do two things with their net income. Consume and save. Consumption requires that we spend money today or in the immediate future whereas saving means that we place importance on money in the distant future. People have different views about consumption and saving. They place different weights on these two actions. Households that place greater weight on consumption do not save as much whereas the opposite is true when greater weight is placed on saving. At the time of the decision making process however, households do not possess the full information so as to take an accurate decision.

In times of economic prosperity, people place greater weight on present consumption. They overestimate the chances that the economy will continue to boom in the future. Thus, they do not save as much. In times of crisis, the weight is displaced towards saving because people overestimate the chances that the economy will continue to be bleak in the future. Thus, households do not spend as much.

The right answer lies somewhere in the middle of these extreme behaviors. For each one of us, the weights of our future actions will be different, depending on how much we earn, our total savings, the current economic conditions. How much would you save?

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