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Induced Uncertainty, Market Price of Risk, and the Dynamics of Consumption and Wealth

Luo, Yulei and Young, Eric (2014): Induced Uncertainty, Market Price of Risk, and the Dynamics of Consumption and Wealth.

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Abstract

In this paper we examine implications of model uncertainty due to robustness (RB) for consumption and saving and the market price of uncertainty under limited information-processing capacity (rational inattention or RI). We first solve the robust permanent income models with inattentive consumers and show that RI by itself creates an additional demand for robustness that leads to higher "induced uncertainty" facing consumers. Second, we explore how the induced uncertainty composed of (i) model uncertainty due to RB and (ii) state uncertainty due to RI, affects consumption-saving decisions and the market price of uncertainty. We find that induced uncertainty can better explain the observed market price of uncertainty -- low attention increases the effect of model mis-specification. We also show the observational equivalence between RB and risk-sensitivity (RS) in environment.

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