A Memory Based Model of Bounded Rationality

43 Pages Posted: 25 Jul 2001

See all articles by Sendhil Mullainathan

Sendhil Mullainathan

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: September 2000

Abstract

How do memory limitations affect economic behavior? I develop a model of memory grounded in psychology and biology research to investigate this question. Using this model, I study the case where people apply Bayes rule to the history they recall as if it were the true history. The resulting beliefs exhibit over-reaction on average. They also exhibit under-reaction with the model providing enough structure to allow predictions about which effect dominates when. I then apply this general framework to an otherwise standard model of consumption. It predicts the broad structure of consumption predictability as well as differences in marginal propensity to consume across different income streams. Most important, because it ties the extent of bias to a measurable aspect of the stochastic process being forecasted, the model makes novel, testable empirical predictions.

Keywords: psychology, biology, Bayes rule, personal economic history, consumption

JEL Classification: A12, B40, E21

Suggested Citation

Mullainathan, Sendhil, A Memory Based Model of Bounded Rationality (September 2000). MIT Dept. of Economics Working Paper No. 01-28. Available at SSRN: https://ssrn.com/abstract=277357 or http://dx.doi.org/10.2139/ssrn.277357

Sendhil Mullainathan (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States
617-496-2720 (Phone)
617-495-7730 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
617-588-1473 (Phone)
617-876-2742 (Fax)

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