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What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

Luo, Yulei and Nie, Jun and Wang, Gaowang and Young, Eric (2014): What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium.

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Abstract

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the Permanent Income Hypothesis (PIH) arises in equilibrium, as in models with full information-rational expectations, due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

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