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Boundedly Rational Dynamic Programming: Some Preliminary Results

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  • Xavier Gabaix

Abstract

A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report ongoing progress that is more fully developed elsewhere. I present some results from a new model in which the decision-maker builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17783.

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Date of creation: Jan 2012
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Handle: RePEc:nbr:nberwo:17783

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  1. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  2. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  3. Laibson, David I. & Gabaix, Xavier, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," Scholarly Articles 4554333, Harvard University Department of Economics.
  4. Xavier Gabaix, 2011. "A Sparsity-Based Model of Bounded Rationality," NBER Working Papers 16911, National Bureau of Economic Research, Inc.
  5. Robert J. Barro, 2007. "Rare Disasters, Asset Prices, and Welfare Costs," NBER Working Papers 13690, National Bureau of Economic Research, Inc.
  6. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
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Cited by:
  1. RĂ¼diger Bachmann & Tim O. Berg & Eric R. Sims, 2012. "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence," NBER Working Papers 17958, National Bureau of Economic Research, Inc.

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