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Rational Inattention, Long-run Consumption Risk, and Portfolio Choice

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  • Yulei Luo

    (University of Hong Kong)

Abstract

This paper explores how the introduction of rational inattention (RI) -- that agents process information subject to finite channel capacity -- affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2010.01.002
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 13 (2010)
Issue (Month): 4 (October)
Pages: 843-860

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Handle: RePEc:red:issued:08-115

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Related research

Keywords: Rational inattention; Long-run consumption risk; Long-term portfolio choice; Aggregate consumption;

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References

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  1. Laura Veldkamp & Stijn Van Nieuwerburgh, 2005. "Information Acquisition and Portfolio Underdiversification," 2005 Meeting Papers 77, Society for Economic Dynamics.
  2. Martha Starr-McCluer, 1998. "Stock market wealth and consumer spending," Finance and Economics Discussion Series 1998-20, Board of Governors of the Federal Reserve System (U.S.).
  3. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity-Premium Puzzle," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 257-330 National Bureau of Economic Research, Inc.
  4. Karen E. Dynan & Dean M. Maki, 2001. "Does stock market wealth matter for consumption?," Finance and Economics Discussion Series 2001-23, Board of Governors of the Federal Reserve System (U.S.).
  5. Jonathan A. Parker, 2003. "Consumption Risk and Expected Stock Returns," American Economic Review, American Economic Association, vol. 93(2), pages 376-382, May.
  6. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies 2005,34, Deutsche Bundesbank, Research Centre.
  7. Bartosz Mackowiak & Mirko Wiederholt, 2008. "Business Cycle Dynamics under Rational Inattention," 2008 Meeting Papers 1059, Society for Economic Dynamics.
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Cited by:
  1. Yulei Luo & Jun Nie & Eric R. Young, 2010. "Robust control, informational frictions, and international consumption correlations," Research Working Paper RWP 10-16, Federal Reserve Bank of Kansas City.
  2. Luo, Yulei & Young, Eric, 2013. "Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention," MPRA Paper 52904, University Library of Munich, Germany.
  3. Luo, Yulei & Young, Eric, 2013. "Rational Inattention in Macroeconomics: A Survey," MPRA Paper 54267, University Library of Munich, Germany.

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