What we don’t know doesn’t hurt us: rational inattention and the permanent income hypothesis in general equilibrium

By Jun Nie, Yulei Luo, Gaowang Wang and Eric Young

http://d.repec.org/n?u=RePEc:fip:fedkrw:rwp14-14&r=dge

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 steady state equilibrium 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.

What I take away from this paper is that general equilibrium effects are impressive. Here we have an environment where economic agents suffer from incomplete information, which should make that the permanent income hypothesis should fail, yet interest rates put them right back on track. One could say that it is not new that prices reveal information that markets participants do not know individually. However, the added difficulty here is that for the hypothesis to hold under complete information, said interest rate needs to align with time preferences. So it is not obvious that things still fall into place once you remove information.

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