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Working Paper
Production and Inventory Dynamics under Ambiguity Aversion
We propose a production-cost smoothing model with Knightian uncertainty due to ambiguity aversion to study the joint behavior of production, inventories, and sales. Our model can explain four facts that previous studies find difficult to account for simultaneously: (i) the high volatility of production relative to sales, (ii) the low ratio of inventory-investment volatility to sales volatility, (iii) the positive correlation between sales and inventories, and (iv) the negative correlation between the inventory-to-sales ratio and sales. We find that the stock-out avoidance motive (Kahn 1987) ...
Working Paper
Model uncertainty, state uncertainty, and state-space models
This technical paper considers ways to capture uncertainty in the context of so-called "state-space" models. ; State-space models are powerful tools commonly used in macroeconomics, international economics, and finance. State-space models can generate estimates of an underlying, ultimately unobserved variable?such as the natural rate of unemployment?based on the movements of other variables that are observed and have some relationship to the unobserved variable. The paper shows how several macroeconomic models can be mapped to the state-space framework, thus helping quantify uncertainty ...
Working Paper
What we don’t know doesn’t hurt us: rational inattention and the permanent income hypothesis in general equilibrium
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 steady state equilibrium 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 ...
Working Paper
Money, Growth, and Welfare in a Schumpeterian Model with the Spirit of Capitalism
According to Schumpeter (1934), entrepreneurs are driven to innovate not only for the fruits of success but for success itself. This description of entrepreneurship echoes Weber’s (1958) description of the “spirit of capitalism,” which states that people enjoy the accumulation of wealth irrespective of its effect on smoothing consumption. This paper explores the implications of the spirit of capitalism on monetary policy, growth, and welfare in a Schumpeterian growth model. Different from the existing literature, we show that money is not superneutral in the long run and could promote ...
Working Paper
Robustness, information-processing constraints, and the current account in small open economies
We examine the effects of two types of informational frictions, robustness (RB) and nite information-processing capacity (called rational inattention or RI) on the current account, in an otherwise standard intertemporal current account (ICA) model. We show that the interaction of RB and RI has the potential to improve the model?s predictions on the joint dynamics of the current account and income: (i) the contemporaneous correlation between the current account and income, (ii) the volatility and persistence of the current account in small open emerging and developed economies. In addition, we ...
Working Paper
Ignorance, Uncertainty, and Strategic Consumption-Portfolio Decisions
This paper constructs a recursive utility version of a canonical Merton (1971) model with uninsurable labor income and unknown income growth to study how the interaction between two types of uncertainty due to ignorance affects strategic consumption-portfolio rules and precautionary savings. Specifically, after solving the model explicitly, we theoretically and quantitatively explore (i) how these ignorance-induced uncertainties interact with intertemporal substitution, risk aversion, and the correlation between the equity return and labor income, and (ii) how they jointly affect strategic ...
Working Paper
Attention Allocation and Heterogenous Consumption Responses
Recessions often have detrimental effects on both employment and equity returns, forcingindividuals to make decisions about how to balance risks to their labor and capital income.In this paper, we study how individuals allocate their limited attention between capital income and labor income risks in a two-period consumption-saving model with recursive utility.Specifically, we examine how the optimal attention and consumption-saving decisions are influenced by individuals’ attention capacity, wealth endowments, income risks, and preferencesfor risk and time. We show that our model can ...
Working Paper
Model uncertainty and intertemporal tax smoothing
In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and debt structure in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB. Furthermore, we show that introducing RB can improve the model?s predictions by generating (i) the observed relative volatility of the changes in tax rates to government spending and (ii) the observed comovement between government deficits and spending, and (iii) more consistent behavior of government ...
Working Paper
Robust control, informational frictions, and international consumption correlations
In this paper we examine the effects of two types of information imperfections, robustness (RB) and nite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in nancial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption ...
Working Paper
Robust permanent income in general equilibrium
This paper provides a tractable continuous-time constant-absolute-risk averse (CARA)-Gaussian framework to quantitatively explore how the preference for robustness (RB) affects the interest rate, the dynamics of consumption and income, and the welfare costs of model uncertainty in general equilibrium. We show that RB significantly reduces the equilibrium interest rate, and reduces the relative volatility of consumption growth to income growth when the income process is stationary. Furthermore, we find that the welfare costs of model uncertainty are nontrivial for plausibly estimated income ...