Behavioral Macroeconomics via Sparse Dynamic Programming

Abstract

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 act according to a behavioral Bellman equation. The framework is applied to some of the canonical models in macroeconomics and finance.

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 is only partially attentive to taxes and policy changes.

The model also yields a behavioral version of the New Keynesian model. It helps solve the "forward guidance puzzle", the fact that in that model, shocks to very distant rates have a very powerful impact on today's consumption and inflation: because the agent is de facto myopic, this effect is muted.

The paper gives a behavioral version of the canonical neoclassical growth model: fluctuations are larger and more persistent as agents do not react optimally to macroeconomic variables. Finally, in a Merton-style dynamic portfolio choice problem, the agent endogenously pays limited or no attention to the varying equity premium and hedging demand terms.

Keywords: Bounded rationality, inattention

JEL Classification: D03, E03, E6, E21, G02