Working Paper: NBER ID: w21848
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 Merton-style 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: Behavioral Economics; Dynamic Programming; Macroeconomics
JEL Codes: D03; E03; E21; E6; G02; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Agents' attention to retirement savings (G51) | Savings behavior (under-saving for retirement) (D14) |
| Limited attention to retirement (J26) | Delayed savings (D15) |
| Attention to interest rates (E43) | Consumption policy responsiveness (D18) |
| Lack of attention to fiscal policies (E62) | Consumption behavior (increased consumption with government transfers) (D19) |
| Nature of policy changes (D78) | Agents' responses (maintaining default policy functions) (D82) |
| Bounded rationality (D01) | Macroeconomic fluctuations (larger and more persistent) (E39) |
| Accumulation of shocks (E32) | Agents' responses (slower reactions) (L85) |