Working Paper: NBER ID: w25478
Authors: Rava Azeredo da Silveira; Michael Woodford
Abstract: We propose a model of optimal decision making subject to a memory constraint. The constraint is a limit on the complexity of memory measured using Shannon’s mutual information, as in models of rational inattention; but our theory differs from that of Sims (2003) in not assuming costless memory of past cognitive states. We show that the model implies that both forecasts and actions will exhibit idiosyncratic random variation; that beliefs will fluctuate forever around the rational-expectations (perfect-memory) beliefs with a variance that does not fall to zero; and that more recent news will be given disproportionate weight. The model provides a simple explanation for a number of features of expectations in laboratory and field settings, most notably apparent over-reaction of both elicited forecasts and spending decisions to transitory fluctuations in economic time series.
Keywords: memory constraints; overreaction; economic decision-making; forecasts; cognitive biases
JEL Codes: D91; E71; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Cognitive limitations (D91) | Economic decision-making (D87) |
| Memory constraints (D24) | Idiosyncratic random variation in forecasts and actions (D80) |
| Memory noise (Y91) | Beliefs fluctuation around rational expectations (D84) |
| Noisy memory (Y50) | Overreaction to economic fluctuations (E32) |
| Memory imprecision (C60) | Consumption behavior (D10) |
| Observable variables (C29) | Predictable forecast errors (C53) |