What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

43 Pages Posted: 28 Nov 2014

See all articles by Jun Nie

Jun Nie

Federal Reserve Bank of Kansas City

Yulei Luo

University of Hong Kong

Gaowang Wang

Shandong University

Eric R. Young

University of Virginia

Date Written: November 24, 2014

Abstract

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

Keywords: Rational Inattention, Permanent Income Hypothesis, General Equilibrium, Consumption and Income Volatility

JEL Classification: C61, E21, D83

Suggested Citation

Nie, Jun and Luo, Yulei and Wang, Gaowang and Young, Eric R., What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium (November 24, 2014). Federal Reserve Bank of Kansas City Working Paper No. 14-14. Available at SSRN: https://ssrn.com/abstract=2531093 or http://dx.doi.org/10.2139/ssrn.2531093

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

Yulei Luo

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

Gaowang Wang

Shandong University ( email )

27 Shanda Nanlu
South Rd.
Jinan, Shandong 250100
China

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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