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Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

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  • Luo, Yulei
  • Young, Eric

Abstract

We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We find that rational inattention combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 52904.

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Date of creation: 08 Jul 2013
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Handle: RePEc:pra:mprapa:52904

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Keywords: Rational Inattention; Recursive Utility; Portfolio Choice; Asset Pricing;

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Cited by:
  1. Luo, Yulei & Young, Eric, 2013. "Rational Inattention in Macroeconomics: A Survey," MPRA Paper 54267, University Library of Munich, Germany.

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