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 misspecification. We also show the observational equivalence between RB and risk-sensitivity (RS) in environment. ∗This paper was previously circulated under tht title “Consumption, Market Price of Risk, and Wealth Accumulation under Induced Uncertainty”. We are indebted to Tom Sargent for helpful guidance and suggestions. We also would like to thank Anmol Bhandari, Jaime Casassus, Richard Dennis, Larry Epstein, Hanming Fang, Lars Hansen, Ken Kasa, Tasos Karantounias, Jae-Young Kim, Rody Manuelli, Jun Nie, Kevin Salyer, Martin Schneider, Chris Sims, Wing Suen, Laura Veldkamp, Mirko Wiederholt, Tack Yun, Shenghao Zhu, and Tao Zhu as well as seminar and conference participants at UC Davis, Hong Kong University of Science and Technology, City University of Hong Kong, University of Toyko, Shanghai University of Finance and Economics, National University of Singapore, Seoul National University, the conference on “Putting Information Into (or Taking it out of) Macroeconomics” organized by LAEF of UCSB, the Summer Meeting of Econometric Society, the conference on “Rational Inattention and Related Theories” organized by CERGE-EI, Prague, the KEA annual meeting, the Fudan Conference on Economic Dynamics, and the Workshop on the Macroeconomics of Risk and Uncertainty at the Banco Central de Chile for helpful discussions and comments. Luo thanks the General Research Fund (GRF No. HKU749711) in Hong Kong and the HKU seed funding program for basic research for financial support. Young thanks the Bankard Fund for Political Economy at the University of Virginia for financial support. All errors are the responsibility of the authors. †School of Economics and Finance, Faculty of Business and Economics, University of Hong Kong, Hong Kong. Email address: [email protected]. ‡Department of Economics, University of Virginia, Charlottesville, VA 22904. E-mail: [email protected].