Working Paper: Restricted Dynamic Consistency

Abstract

Dynamic consistency is a key behavioral property in dynamic models, enabling tractability by means of dynamic programming methods. However, it is a behavioral property that is often violated in experiments. This paper shows that dynamic consistency can be relaxed to hold over a much smaller domain of consumption programs. Nonetheless, this domain can still be sufficiently rich for practical applications. To illustrate, I provide examples of domains that are rich enough to separate risk aversion from intertemporal substitution. As an application, I introduce a new model of dynamic preferences, the Epstein- Zin-Selden-Stux preferences. These preferences are recursive only within a restricted domain. In contrast with standard recursive preferences, this weaker notion of dynamic consistency allows for indifference to the timing of resolution of uncertainty.