Risk-Sensitive Consumption and Savings under Rational Inattention

48 Pages Posted: 9 Nov 2008

See all articles by Yulei Luo

Yulei Luo

University of Hong Kong

Eric R. Young

University of Virginia

Date Written: November 8, 2008


This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI). We first solve the model explicitly and show that RI increases precautionary savings by interacting with income uncertainty and risk-sensitivity. Given the closed-form solutions, we find that the RI model displays a wide range of observational equivalence properties, implying that consumption and savings data cannot distinguish between risk-sensitivity, robustness, or the discount factor, in any combination. We then show that the welfare costs from RI are much larger for risk-sensitive households than any other observationally-equivalent settings. Thus, a potential method for testing risk-sensitivity vs. robustness is to ask agents how much they would pay to receive better information about the state of the world.

Suggested Citation

Luo, Yulei and Young, Eric R., Risk-Sensitive Consumption and Savings under Rational Inattention (November 8, 2008). Available at SSRN: https://ssrn.com/abstract=1297847 or http://dx.doi.org/10.2139/ssrn.1297847

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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