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Robust Control, Informational Frictions, and International Consumption Correlations

  • Yulei Luo

    (University of Hong Kong)

  • Eric R.Young

    (University of Virginia)

  • Jun Nie

    (Federal Reserve Bank of Kansas City)

In this paper we examine the effects of two types of information imperfections, robustness (RB) and finite 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 financial markets, RB lowers the international consumption correlations by introducing heterogenous 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 Society for Economic Dynamics in its series 2011 Meeting Papers with number 209.

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Date of creation: 2011
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Handle: RePEc:red:sed011:209
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