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Consumption Dynamics under Information Processing Constraints

  • Yulei Luo

    (Princeton University)

This paper studies consumption dynamics and welfare losses under information processing constraints (it is also called 'rational inattention' (RI) in Sims (2003)) in the permanent income hypothesis (PIH) model. It is shown that incorporating RI into the otherwise standard PIH model can substantially affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects. Specifically, the main contributions of this paper are: first, we propose a tractable analytical approach to solve the multivariate state PIH model with RI and show that consumption reacts to the shocks to wealth gradually and with delay; second, after aggregating, we show that incorporating RI into the model can help resolve the excess sensitivity puzzle and the excess smoothness puzzle; third, we also find that the utility costs due to RI are very trivial, which can rationalize a key assumption in Sims (2003) that consumers only devote low channel capacity in observing and processing information; fourth, we investigate which factors determine optimal channel capacity endogeneously; finally, we compare our RI model with the standard internal habit formation model and the Campbell-Mankiw's rule-of-thumb model.

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File URL: http://econwpa.repec.org/eps/mac/papers/0505/0505011.pdf
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Paper provided by EconWPA in its series Macroeconomics with number 0505011.

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Length: 41 pages
Date of creation: 13 May 2005
Date of revision: 03 Jun 2005
Handle: RePEc:wpa:wuwpma:0505011
Note: Type of Document - pdf; pages: 41
Contact details of provider: Web page: http://econwpa.repec.org

References listed on IDEAS
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  1. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Working Papers 2924, National Bureau of Economic Research, Inc.
  2. Marvin Goodfriend, 1991. "Information-aggregation bias," Working Paper 91-06, Federal Reserve Bank of Richmond.
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  6. Carroll, Christopher D., 2009. "Precautionary saving and the marginal propensity to consume out of permanent income," Journal of Monetary Economics, Elsevier, vol. 56(6), pages 780-790, September.
  7. Laurence Ball & N. Gregory Mankiw & Ricardo Reis, 2003. "Monetary Policy for Inattentive Economies," Harvard Institute of Economic Research Working Papers 1997, Harvard - Institute of Economic Research.
  8. Campbell, John Y & Deaton, Angus, 1989. "Why Is Consumption So Smooth?," Review of Economic Studies, Wiley Blackwell, vol. 56(3), pages 357-73, July.
  9. Ricardo Reis, 2004. "Inattentive Consumers," NBER Working Papers 10883, National Bureau of Economic Research, Inc.
  10. Gali, Jordi, 1991. "Budget Constraints and Time-Series Evidence on Consumption," American Economic Review, American Economic Association, vol. 81(5), pages 1238-53, December.
  11. Lawrence J. Christiano, 1987. "Why is consumption less volatile than income?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 2-20.
  12. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-57, April.
  13. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  14. Hall, Robert E & Mishkin, Frederic S, 1982. "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households," Econometrica, Econometric Society, vol. 50(2), pages 461-81, March.
  15. Campbell, John Y & Mankiw, N Gregory, 1990. "Permanent Income, Current Income, and Consumption," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(3), pages 265-79, July.
  16. Caballero, Ricardo J., 1990. "Consumption puzzles and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 113-136, January.
  17. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October.
  18. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September.
  19. Sims, Christopher A., 2005. "Rational inattention: a research agenda," Discussion Paper Series 1: Economic Studies 2005,34, Deutsche Bundesbank, Research Centre.
  20. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
  21. Pischke, J.S., 1993. "Individual Income, Incomplete Information, and Aggregate Consumption," Working papers 93-16, Massachusetts Institute of Technology (MIT), Department of Economics.
  22. Mirko Wiederholt & Bartosz Mackowiak, 2005. "Optimal Sticky Prices under Rational Inattention," 2005 Meeting Papers 369, Society for Economic Dynamics.
  23. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
  24. repec:fth:harver:1435 is not listed on IDEAS
  25. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Harvard Institute of Economic Research Working Papers 1922, Harvard - Institute of Economic Research.
  26. John Y. Campbell, 1986. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," NBER Working Papers 1805, National Bureau of Economic Research, Inc.
  27. Cochrane, John H, 1989. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," American Economic Review, American Economic Association, vol. 79(3), pages 319-37, June.
  28. Nicholas S. Souleles, 1999. "The Response of Household Consumption to Income Tax Refunds," American Economic Review, American Economic Association, vol. 89(4), pages 947-958, September.
  29. Alessie, Rob & Lusardi, Annamaria, 1997. "Consumption, saving and habit formation," Economics Letters, Elsevier, vol. 55(1), pages 103-108, August.
  30. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 305-325, March.
  31. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, vol. 91(3), pages 631-647, June.
  32. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  33. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  34. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June.
  35. Michael Woodford, 2001. "Imperfect Common Knowledge and the Effects of Monetary Policy," NBER Working Papers 8673, National Bureau of Economic Research, Inc.
  36. Jonathan A. Parker, 1999. "The Reaction of Household Consumption to Predictable Changes in Social Security Taxes," American Economic Review, American Economic Association, vol. 89(4), pages 959-973, September.
  37. Weil, Philippe, 1993. "Precautionary Savings and the Permanent Income Hypothesis," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 367-83, April.
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  39. repec:cup:macdyn:v:1:y:1997:i:2:p:312-32 is not listed on IDEAS
  40. Luo Yulei & Young Eric R, 2009. "Rational Inattention and Aggregate Fluctuations," The B.E. Journal of Macroeconomics, De Gruyter, vol. 9(1), pages 1-43, April.
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