Working Paper: CEPR ID: DP11026
Authors: Xavier Gabaix
Abstract: This paper proposes a tractable way to model boundedly rational dynamic programming. The agent uses an endogenously simplified, or "sparse," model of the world and the consequences of his actions and acts according to a behavioral Bellman equation. The framework yields a behavioral version of some of the canonical models in macroeconomics and finance. In the life-cycle model, the agent initially does not pay much attention to retirement and undersaves; late in life, he progressively saves more, generating realistic dynamics. In the consumption-savings model, the consumer decides to pay little or no attention to the interest rate and more attention to his income. Ricardian equivalence and the Lucas critique partially fail because the consumer may not pay full attention to taxes and policy changes. In a Mertonstyle dynamic portfolio choice problem, the agent endogenously pays limited or no attention to the varying equity premium and hedging demand terms. Finally, in the neoclassical growth model, agents act on a simplified model of the macroeconomy; in equilibrium, fluctuations are larger and more persistent.
Keywords: bounded rationality; inattention; simplification
JEL Codes: D03; E03; E21; E6; G02
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bounded rationality (D01) | under-saving for retirement (D14) |
| lack of attention to retirement savings (D14) | increase in savings as agents approach retirement (D14) |
| simplified mental models (D91) | lack of attention to retirement savings (D14) |
| bounded rationality (D01) | ignoring interest rates in consumption-savings decisions (D15) |
| bounded rationality (D01) | increased attention to income in consumption-savings decisions (E21) |
| simplification of decision-making process (D91) | suboptimal financial outcomes (G19) |
| bounded rationality (D01) | failure of Ricardian equivalence (H39) |
| not accounting for tax implications (H24) | increased consumption in response to government transfers (H59) |
| limited attention to aggregate variables (E10) | larger and more persistent macroeconomic fluctuations (E32) |
| limited attention to aggregate variables (E10) | slower mean reversion of capital following shocks (C22) |