Robust Control, Information Frictions, and International Consumption Correlations

48 Pages Posted: 9 Jan 2011 Last revised: 11 Mar 2013

See all articles by Jun Nie

Jun Nie

Federal Reserve Bank of Kansas City

Eric R. Young

University of Virginia

Yulei Luo

University of Hong Kong

Date Written: September 1, 2012

Abstract

In this paper we examine the effects of two types of information imperfections, robustness (RB) and finite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. We then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noise shocks that reduce the correlations.

Keywords: Robustness, Rational Inattention, Risk Sharing, International Consumption Correlations

JEL Classification: D83, E21, F41, G15

Suggested Citation

Nie, Jun and Young, Eric R. and Luo, Yulei, Robust Control, Information Frictions, and International Consumption Correlations (September 1, 2012). Available at SSRN: https://ssrn.com/abstract=1736134 or http://dx.doi.org/10.2139/ssrn.1736134

Jun Nie (Contact Author)

Federal Reserve Bank of Kansas City ( email )

1 Memorial Drive
Kansas City, MO 64198
United States
(816) 881-2255 (Phone)
(816) 881-2199 (Fax)

HOME PAGE: http://homepages.nyu.edu/~jn461/research.htm

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

Yulei Luo

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

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