Rational Inattention and Dynamics of Consumption and Wealth in General Equilibrium
University of Hong Kong
Federal Reserve Bank of Kansas City
Eric R. Young
University of Virginia
May 17, 2016
Federal Reserve Bank of Kansas City Working Paper No. 14-14
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.
Note: 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.”
Number of Pages in PDF File: 51
Keywords: Rational Inattention; Permanent Income Hypothesis; General Equilibrium; Con-sumption and Wealth Volatility.
JEL Classification: C61; D83; E21.
Date posted: May 23, 2016