Working Paper: CEPR ID: DP8813
Authors: Xavier Gabaix
Abstract: A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report on ongoing progress that is more fully developed elsewhere. I present some results from a new model with boundedly rational features in which the decision-maker (DM) builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.
Keywords: Behavioral Economics; Bounded Rationality; Inattention; Intertemporal Elasticity of Substitution
JEL Codes: D03; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| DM's attention to income vs. interest rates (E43) | biased Euler equations (C46) |
| DM's attention to income vs. interest rates (E43) | low intertemporal elasticity of substitution (IES) (D15) |
| low intertemporal elasticity of substitution (IES) (D15) | consumption behavior (D10) |
| bounded rationality (D01) | consumption insensitivity to interest rates (E21) |
| bounded rationality of consumers (D11) | biased IES estimates (C51) |