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Robust control, informational frictions, and international consumption correlations

Listed author(s):
  • Yulei Luo
  • Jun Nie
  • Eric R. Young

In this paper we examine the effects of two types of information imperfections, robustness (RB) and nite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in nancial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. We then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noise shocks that reduce the correlations.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 10-16.

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Date of creation: 2010
Handle: RePEc:fip:fedkrw:rwp10-16
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