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

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

http://d.repec.org/n?u=RePEc:red:sed015:280&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.

Pretty neat paper that shows that the permanent income hypothesis is more powerful that what you would think. And we need to worry less about incomplete markets than what we previously thought.

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2 Responses to What We Don’t Know Doesn’t Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

  1. Eric Young says:

    You must really like our paper, because this is second time you’ve reviewed it here. We have another one on robustness in general equilibrium, in case you would like to read that one.

    Cheers,

    Eric

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