Rational Inattention and Dynamics of Consumption and Wealth in General Equilibrium

51 Pages Posted: 23 May 2016  

Yulei Luo

University of Hong Kong

Jun Nie

Federal Reserve Bank of Kansas City

Gaowang Wang

Shandong University

Eric R. Young

University of Virginia

Date Written: May 17, 2016

Abstract

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We first 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 explore how the introduction of RI can help the model fit the joint equilibrium dynamics of consumption, income, and wealth. We then contrast RI with habit formation and show that the two models make very different general equilibrium predictions, and that RI is closer to the data. We finally show that the equilibrium welfare costs of incomplete information due to RI are relatively low within the CARA-Gaussian setting.

Notes: An earlier version of this paper was circulated under the title: “What We Don’t Know Doesn’t Hurt Us: Rational Inattention and the Permanent Income Hypothesis.”

Keywords: Rational Inattention; Permanent Income Hypothesis; General Equilibrium; Con-sumption and Wealth Volatility.

JEL Classification: C61; D83; E21.

Suggested Citation

Luo, Yulei and Nie, Jun and Wang, Gaowang and Young, Eric R., Rational Inattention and Dynamics of Consumption and Wealth in General Equilibrium (May 17, 2016). Federal Reserve Bank of Kansas City Working Paper No. 14-14. Available at SSRN: https://ssrn.com/abstract=2782621 or http://dx.doi.org/10.2139/ssrn.2782621

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

Jun Nie

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

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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