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Durable Consumption and Asset Management with Transaction and Observation Costs

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  • Fernando Alvarez

    (University of Chicago)

  • Luigi Guiso

    (European University Institute and EIEF)

  • Francesco Lippi

    (University of Sassari and EIEF)

Abstract

The empirical evidence on rational inattention lags far behind the theoretical developments: micro evidence on the most immediate consequence of observation costs (the infrequent observation of state variables) is not available in standard datasets. We contribute to filling the gap with two novel household surveys that record the frequency with which investors observe the value of their financial investments, as well as the frequency with which they trade in financial assets and durable goods. We use these data to quantify the importance of the observation cost relative to standard transaction cost. It is shown that to match the patterns in the data we need to modify the existing models by shifting the focus from non-durable to durable consumption. The model we develop features both observation and transaction costs and implies a mixture of timedependent and state-dependent rules, where the importance of each rule depends on the ratio of the observation to the transaction cost. Numerical simulations show that the model can produce frequency of portfolio observations and asset trading comparable to that of the median Italian investor (about 4 and 0.4 per year, respectively) with small observation costs (about 1 basis point of financial wealth) and larger transaction costs (about 30 basis points of financial wealth). In spite of its small size the observation cost gives rise to infrequent information gathering (between monthly and quarterly). A quantitative assessment of the relevance of the observation costs shows that the behavior of the investors is essentially unchanged compared to the one produced by a model with transaction but no observation cost. We test a novel prediction of the model on the relationship between assets trades and durable-goods trades and find that it is aligned with the data.

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Bibliographic Info

Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1001.

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Length: 57 pages
Date of creation: 2010
Date of revision: Jan 2010
Handle: RePEc:eie:wpaper:1001

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References

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  1. Luigi Guiso & Tullio Jappelli, 2006. "Information Acquisition and Portfolio Performance," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 167, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  2. YiLi Chien & Harold Cole & Hanno Lustig, 2012. "Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Rebalancing?," American Economic Review, American Economic Association, American Economic Association, vol. 102(6), pages 2859-96, October.
  3. Alvarez, Fernando E & Lippi, Francesco & Paciello, Luigi, 2010. "Optimal price setting with observation and menu costs," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7861, C.E.P.R. Discussion Papers.
  4. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies 2005,34, Deutsche Bundesbank, Research Centre.
  5. Orazio Attanasio & Luigi Guiso & Tuillo Jappelli, 1998. "The Demand for Money, Financial Innovation, and the Welfare Cost of Inflation: An Analysis with Household Data," NBER Working Papers 6593, National Bureau of Economic Research, Inc.
  6. Stokey, Nancy L., 2009. "Moving costs, nondurable consumption and portfolio choice," Journal of Economic Theory, Elsevier, Elsevier, vol. 144(6), pages 2419-2439, November.
  7. Verrecchia, Robert E, 1982. "Information Acquisition in a Noisy Rational Expectations Economy," Econometrica, Econometric Society, Econometric Society, vol. 50(6), pages 1415-30, November.
  8. Guiso, Luigi & Paiella, Monica, 2001. "Risk Aversion, Wealth and Background Risk," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2728, C.E.P.R. Discussion Papers.
  9. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2003. "On the Sluggish Response of Prices to Money in an Inventory-Theoretic Model of Money Demand," NBER Working Papers 10016, National Bureau of Economic Research, Inc.
  10. Alvarez, Fernando E & Lippi, Francesco, 2007. "Financial Innovation and the Transactions Demand for Cash," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6472, C.E.P.R. Discussion Papers.
  11. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky information versus sticky prices: a proposal to replace the New-Keynesian Phillips curve," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Jun.
  12. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 1947, Harvard - Institute of Economic Research.
  13. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2009. "Sluggish Responses of Prices and Inflation to Monetary Shocks in an Inventory Model of Money Demand," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 124(3), pages 911-967, August.
  14. Yosef Bonaparte & Russell Cooper, 2009. "Costly Portfolio Adjustment," NBER Working Papers 15227, National Bureau of Economic Research, Inc.
  15. Grossman, Sanford J & Laroque, Guy, 1990. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Econometrica, Econometric Society, Econometric Society, vol. 58(1), pages 25-51, January.
  16. Reis, Ricardo, 2005. "Inattentive Consumers," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5053, C.E.P.R. Discussion Papers.
  17. Andrew B. Abel & Janice C. Eberly & Stavros Panageas, 2007. "Optimal Inattention to the Stock Market," American Economic Review, American Economic Association, American Economic Association, vol. 97(2), pages 244-249, May.
  18. Joël Peress, 2004. "Wealth, Information Acquisition, and Portfolio Choice," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 17(3), pages 879-914.
  19. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(3), pages 665-690, April.
  20. Duffie, Darrell & Sun, Tong-sheng, 1990. "Transactions costs and portfolio choice in a discrete-continuous-time setting," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 14(1), pages 35-51, February.
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Citations

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Cited by:
  1. Fernando Alvarez & Francesco Lippi, 2012. "The Demand of Liquid Assets with Uncertain Lumpy Expenditures," NBER Working Papers 18152, National Bureau of Economic Research, Inc.
  2. Fernando E. Alvarez & Francesco Lippi & Luigi Paciello, 2011. "Optimal Price Setting With Observation and Menu Costs," The Quarterly Journal of Economics, Oxford University Press, vol. 126(4), pages 1909-1960.
  3. Aubhik Khan & Julia Thomas, . "Revisiting the Tale of Two Interest Rates with Endogenous Market Segmentation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
  4. Verona, Fabio, 2013. "Investment dynamics with information costs," Research Discussion Papers, Bank of Finland 18/2013, Bank of Finland.
  5. Kanda Naknoi & YiLi Chien, 2013. "The Risk Premium and Long-Run Global Imbalances," 2013 Meeting Papers, Society for Economic Dynamics 55, Society for Economic Dynamics.
  6. Nikolai Roussanov & Michael Michaux & Hui Chen, 2011. "Houses as ATMs? Mortgage Refinancing and Macroeconomic Uncertainty," 2011 Meeting Papers 1369, Society for Economic Dynamics.
  7. Riccardo Giacomelli & Elisa Luciano, 2011. "Equilibrium price of immediacy and infrequent trade," Carlo Alberto Notebooks, Collegio Carlo Alberto 221, Collegio Carlo Alberto, revised 2013.
  8. Jeffrey V. Butler & Luigi Guiso & Tullio Jappelli, 2011. "The role of intuition and reasoning in driving aversion to risk and ambiguity," EIEF Working Papers Series 1107, Einaudi Institute for Economics and Finance (EIEF), revised Oct 2011.
  9. Guiso, Luigi & Sodini, Paolo, 2012. "Household Finance: An Emerging Field," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8934, C.E.P.R. Discussion Papers.
  10. Fernanda Nechio, 2010. "Foreign stock holdings: the role of information," Working Paper Series, Federal Reserve Bank of San Francisco 2010-26, Federal Reserve Bank of San Francisco.

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