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Induced uncertainty, market price of risk, and the dynamics of consumption and wealth

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  • Luo, Yulei
  • Young, Eric R.

Abstract

In this paper we examine the implications of model uncertainty or robustness (RB) for consumption and saving and the market price of uncertainty under limited information-processing capacity (rational inattention or RI). First, we show that RI by itself creates an additional demand for robustness that leads to higher “induced uncertainty” facing consumers. Second, if we allow capacity to be elastic, RB increases the optimal level of attention. Third, we explore how the induced uncertainty composed of (i) model uncertainty due to RB and (ii) state uncertainty due to RI, affects consumption and wealth dynamics, the market price of uncertainty, and the welfare losses due to incomplete information. We find that induced uncertainty can better explain the observed consumption-income volatility and market price of uncertainty – low attention increases the effect of model misspecification.

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  • Luo, Yulei & Young, Eric R., 2016. "Induced uncertainty, market price of risk, and the dynamics of consumption and wealth," Journal of Economic Theory, Elsevier, vol. 163(C), pages 1-41.
  • Handle: RePEc:eee:jetheo:v:163:y:2016:i:c:p:1-41
    DOI: 10.1016/j.jet.2016.01.003
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    3. Gaowang Wang & Juanjuan Yan, 2016. "Robustness, the Spirit of Capitalism and Asset Pricing," Economics Bulletin, AccessEcon, vol. 36(4), pages 1892-1903.
    4. Penghui Yin, 2018. "Optimal Amount of Attention to Capital Income Risk and Heterogeneous Precautionary Saving Behavior," CESifo Working Paper Series 7413, CESifo.

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    More about this item

    Keywords

    Robust control and filtering; Optimal inattention; Induced uncertainty; Market prices of uncertainty; Consumption and income volatility;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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