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Rational Inattention, Long-run Consumption Risk, and Portfolio Choice

  • Yulei Luo

    (University of Hong Kong)

This paper explores how the introduction of rational inattention (RI) -- that agents process information subject to finite channel capacity -- affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium. (Copyright: Elsevier)

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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 13 (2010)
Issue (Month): 4 (October)
Pages: 843-860

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Handle: RePEc:red:issued:08-115
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  1. Laura Veldkamp & Stijn Van Nieuwerburgh, 2005. "Information Acquisition and Portfolio Underdiversification," 2005 Meeting Papers 77, Society for Economic Dynamics.
  2. Mackowiak, Bartosz Adam & Wiederholt, Mirko, 2010. "Business Cycle Dynamics under Rational Inattention," CEPR Discussion Papers 7691, C.E.P.R. Discussion Papers.
  3. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies 2005,34, Deutsche Bundesbank, Research Centre.
  4. Jonathan A. Parker, 2003. "Consumption Risk And Expected Stock Returns," Working Papers 144, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
  5. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers 1947, Harvard - Institute of Economic Research.
  6. Karen E. Dynan & Dean M. Maki, 2001. "Does stock market wealth matter for consumption?," Finance and Economics Discussion Series 2001-23, Board of Governors of the Federal Reserve System (U.S.).
  7. Martha Starr-McCluer, 1998. "Stock market wealth and consumer spending," Finance and Economics Discussion Series 1998-20, Board of Governors of the Federal Reserve System (U.S.).
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