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What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

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  • Luo, Yulei
  • Nie, Jun
  • Wang, Gaowang
  • Young, Eric

Abstract

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the Permanent Income Hypothesis (PIH) arises in equilibrium, as in models with full information-rational expectations, due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

Suggested Citation

  • Luo, Yulei & Nie, Jun & Wang, Gaowang & Young, Eric, 2014. "What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium," MPRA Paper 59182, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:59182
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    References listed on IDEAS

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    Cited by:

    1. 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.

    More about this item

    Keywords

    Rational Inattention; Permanent Income Hypothesis; General Equilibrium; Consumption and Income Volatility.;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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