DP11026 Behavioral Macroeconomics Via Sparse Dynamic Programming

Author(s): Xavier Gabaix
Publication Date: December 2015
Keyword(s): Bounded rationality, inattention, simplification
JEL(s): D03, E03, E21, E6, G02
Programme Areas: Public Economics, Financial Economics, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11026

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 Mertonstyle 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.