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Consumption, Market Price of Risk, and Wealth Accumulation under Induced Uncertainty

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  • Luo, Yulei
  • Young, Eric

Abstract

In this paper we examine implications of model uncertainty due to robustness (RB) for consumption-saving, market price of uncertainty, and aggregate wealth accumulation under limited information-processing capacity (rational inattention or RI) in an otherwise standard permanent income model. We first solve the robust permanent income models with inattentive consumers and show that RI by itself creats an additional demand for robustness that leads to higher ¡°induced uncertainty¡± facing consumers. Second, we explore how the induced uncertainty composed by (i) model uncertainty due to RB and (ii) state uncertainty due to RI, affects consumption-saving decisions and the market price of uncertainty. Particurly, we find that induced uncertainty can better explain the observed market price of uncertainty. Furthermore, we explore the observational equivalence between RB and risk-sensitivity (RS) in this filtering problem. Finally, we evaluate the importance of induced uncertainty and fundamental uncertainty in determining equilibrium aggregate wealth.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 50998.

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Date of creation: 10 Oct 2013
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Handle: RePEc:pra:mprapa:50998

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Keywords: Robust Filtering; Rational Inattention; Observational Equivalence; Induced Uncertainty; Market Prices of Uncertainty; Wealth Accumulation;

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  1. Sun, Yeneng, 2006. "The exact law of large numbers via Fubini extension and characterization of insurable risks," Journal of Economic Theory, Elsevier, vol. 126(1), pages 31-69, January.
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  13. Neng Wang, 2003. "Caballero Meets Bewley: The Permanent-Income Hypothesis in General Equilibrium," American Economic Review, American Economic Association, vol. 93(3), pages 927-936, June.
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