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Boundedly Rational Dynamic Programming: Some Preliminary Results

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  • Xavier Gabaix

Abstract

A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report ongoing progress that is more fully developed elsewhere. I present some results from a new model in which the decision-maker builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.

Suggested Citation

  • Xavier Gabaix, 2012. "Boundedly Rational Dynamic Programming: Some Preliminary Results," NBER Working Papers 17783, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17783
    Note: AG EFG
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    References listed on IDEAS

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    1. Xavier Gabaix, 2014. "A Sparsity-Based Model of Bounded Rationality," The Quarterly Journal of Economics, Oxford University Press, vol. 129(4), pages 1661-1710.
    2. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, August.
    3. Xavier Gabaix & David Laibson, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 121(2), pages 505-540.
    4. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-357, April.
    5. Andreas Fuster & David Laibson & Brock Mendel, 2010. "Natural Expectations and Macroeconomic Fluctuations," Journal of Economic Perspectives, American Economic Association, vol. 24(4), pages 67-84, Fall.
    6. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
    7. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
    8. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity-Premium Puzzle," NBER Chapters,in: NBER Macroeconomics Annual 2001, Volume 16, pages 257-330 National Bureau of Economic Research, Inc.
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    Cited by:

    1. RĂ¼diger Bachmann & Tim O. Berg & Eric R. Sims, 2015. "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence," American Economic Journal: Economic Policy, American Economic Association, vol. 7(1), pages 1-35, February.

    More about this item

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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