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

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  1. Karen E. Dynan & Dean M. Maki, 2001. "Does stock market wealth matter for consumption?," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2001-23, Board of Governors of the Federal Reserve System (U.S.).
  2. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies, Deutsche Bundesbank, Research Centre 2005,34, Deutsche Bundesbank, Research Centre.
  3. Mackowiak, Bartosz Adam & Wiederholt, Mirko, 2010. "Business Cycle Dynamics under Rational Inattention," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7691, C.E.P.R. Discussion Papers.
  4. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity-Premium Puzzle," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2001, Volume 16, pages 257-330 National Bureau of Economic Research, Inc.
  5. Jonathan A. Parker, 2003. "Consumption Risk And Expected Stock Returns," Working Papers, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics. 144, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
  6. Martha Starr-McCluer, 2002. "Stock Market Wealth and Consumer Spending," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 40(1), pages 69-79, January.
  7. Laura Veldkamp & Stijn Van Nieuwerburgh, 2005. "Information Acquisition and Portfolio Underdiversification," 2005 Meeting Papers, Society for Economic Dynamics 77, 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, Federal Reserve Bank of Kansas City RWP 10-16, Federal Reserve Bank of Kansas City.
  2. Luo, Yulei & Young, Eric, 2013. "Rational Inattention in Macroeconomics: A Survey," MPRA Paper 54267, University Library of Munich, Germany.
  3. 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.

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