Social Status, the Spirit of Capitalism, and the Term Structure of Interest Rates in Stochastic Production Economies

This paper studies capital accumulation and equilibrium interest rates in stochastic production economies with the concern of social status. Given a specific utility function and production function, explicit solutions for capital accumulation and equilibrium interest rates have been derived. With the aid of steady-state distributions for capital stock, the effects of fiscal policies, social-status concern, and stochastic shocks on capital accumulation and equilibrium interest rates have been investigated. A significant finding of this paper is the demonstration of multiple stationary distributions for capital stocks and interest rates with the concern of social status.Stochastic growth, Social status, Fiscal policies, Interest rates

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 show that the two informational frictions could also better explain consumption dynamics in small open economies: the impulse responses of consumption to income shocks and the relative volatility of consumption growth to income growth. Calibrated versions using detection probabilities t the data better along these dimensions than the standard model does.

A Note on Entrepreneurial Risk, Capital Market Imperfections, and Heterogeneity

Empirical evidence shows that entrepreneurs hold a large fraction of wealth, have higher saving rates than workers, and face substantial uninsurable entrepreneurial and investment risks. This paper constructs a heterogeneous-agent general equilibrium model with uninsurable entrepreneurial risk and capital market imperfections to explore the implications of uninsurable entrepreneurial risk for wealth distribution and aggregate activity in an incomplete market economy. It is shown that entrepreurial risk can substantially affect both the wealth distribution and the macroeconomy.Wealth Distribution, Idiosyncratic Entrepreneurial Risk, Incomplete Capital Markets

The Spirit of Capitalism and Excess Smoothness

In a recent paper [Luo, Smith, and Zou (2009)] we showed that the spirit of capitalism could in theory resolve the two fundamental anomalies of modern consumption theory, excess sensitivity and excess smoothness. However, that basic model could not plausibly explain the empirical magnitude of excess smoothness. In this paper we develop two extensions of the model ¡ª one with transitory and permanent shocks to income, the other with a stochastic interest rate ¡ª that where the spirit of capitalism can explain excess smoothness.The spirit of capitalism, Consumption smoothing, Interest rate risk

Strategic Consumption-Portfolio Rules with Informational Frictions

This paper provides a tractable continuous-time CARA-Gaussian framework to explore how the interactions of risk aversion and induced uncertainty due to informational frictions determine strategic consumption-portfolio rules, precautionary savings, and consumption dynamics in the presence of uninsurable labor income. Specifically, after solving the model explicitly, we explore the relative importance of the two types of induced uncertainty: (i) model uncertainty due to robustness and (ii) state uncertainty due to limited information-processing capacity as well as risk aversion in determining asset allocation, precautionary savings, and consumption dynamics. Finally, we discuss how the separation between risk aversion and intertemporal substitution affects strategic asset allocation and precautionary savings

Robustly Strategic Consumption-Portfolio Rules with Informational Frictions

This paper provides a tractable continuous-time constant-absolute-risk averse (CARA)-Gaussian framework to explore how the interactions of fundamental uncertainty, model uncertainty due to a preference for robustness (RB), and state uncertainty due to information-processing constraints (rational inattention or RI) affect strategic consumption-portfolio rules and precautionary savings in the presence of uninsurable labor income. Specifically, after solving the model explicitly, I compute and compare the elasticities of strategic asset allocation and precautionary savings to risk aversion, robustness, and inattention. Furthermore, for plausibly estimated and calibrated model parameters, I quantitatively analyze how the interactions of model uncertainty and state uncertainty affect the optimal share invested in the risky asset, and show that they can provide a potential explanation for the observed stockholding behavior of households with different education and income levels

Strategic Consumption-Portfolio Rules and Precautionary Savings with Informational Frictions

This paper provides a tractable continuous-time CARA-Gaussian framework to explore how the interactions of risk aversion and induced uncertainty due to informational frictions determine strategic consumption-portfolio rules, precautionary savings, and consumption dynamics in the presence of uninsurable labor income. Specifically, after solving the model explicitly, we explore the relative importance of the two types of induced uncertainty: (i) model uncertainty due to robustness and (ii) state uncertainty due to limited information-processing capacity as well as risk aversion in determining asset allocation, precautionary savings, and consumption dynamics. Finally, we discuss how the separation between risk aversion and intertemporal substitution affects strategic asset allocation and precautionary savings

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

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

Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We find that rational inattention combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income

Long-run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We find that rational inattention combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income