Household Consumption and Dispersed Information

We study the effects of aggregate income shocks in a small open economy heterogeneous agent model. By introducing a standard information friction, we are able to explain two patterns of small economies experiencing large income changes: (1) excess volatility in consumption and (2) household consumption elasticities that have low correlation with income. With a standard dispersed information structure, households cannot distinguish aggregate income shocks from idiosyncratic ones. Therefore their consumption responds excessively to aggregate income changes, which they forecast as likely to be more persistent than they would if they had full information. We demonstrate that this effect occurs at all points in the income distribution, lowering the correlation of the consumption elasticity with income. Finally, we corroborate our central mechanism using survey data on household expectations of their future income.