Empirical Tests of Rational Inattention

Paper Session

Saturday, Jan. 7, 2017 2:30 PM – 4:30 PM

Hyatt Regency Chicago, Addams
Hosted By: Econometric Society
  • Chair: Mark Dean, Columbia University

Discrete Adjustment to a Changing Environment: Experimental Evidence

Luminita Stevens
,
University of Maryland and Federal Reserve Bank of Minneapolis
MelWin Khaw
,
Columbia University
Michael Woodford
,
Columbia University

Abstract

We conduct a laboratory experiment to shed light on the cognitive limitations that might affect the way decision makers respond to changes in their economic environment. The subjects solve a simple tracking problem: they must estimate the hidden probability of green rings in a box with green and red rings. The hidden probability changes stochastically. Subjects draw rings from the box and indicate their draw-by- draw estimate of this probability. We use the data to test a variety of competing hypotheses about the nature of expectation formation and adjustment of a continuous decision variable to changing conditions. We find that subjects adjust their estimate of the state in discrete jumps rather than after each new observation, even though there are no explicit costs of adjusting one's estimate. Moreover, subjects adjust their estimates by both large and small amounts, as steps of all sizes are common, contrary to the predictions of a simple Ss model of optimal adjustment subject to a fixed cost. Mean errors are relatively small and changes are detected relatively quickly; nonetheless, our subjects depart from the optimal Bayesian benchmark in meaningful ways. We find that while the current "gap" between an optimal Bayesian observer's estimate and the subject's current estimate is an important predictor of whether the subject adjusts her estimate, as posited by the "generalized Ss" model of Caballero and Engel, this gap does not identify too precisely where the subject moves her estimate when an adjustment occurs. We compare our experimental evidence with empirical evidence on price setting by firms, both with regard to the joint distribution of size and frequency of adjustments of individual prices, and with regard to the impulse response function of average prices to a shift in the optimal level of prices.

Inflation Expectations, Learning and Supermarket Prices: Evidence From Survey Experiments

Ricardo Perez-Truglia
,
Microsoft Research
Alberto Felipe Cavallo
,
Massachusetts Institute of Technology
Guillermo Cruces
,
CEDLAS and National University of La Plata

Abstract

Information frictions play a central role in the formation of household inflation expectations, but there is no consensus about their origins. We address this question with novel evidence from survey experiments. We document two main findings. First, individuals in lower-inflation contexts have significantly weaker priors about the inflation rate. This finding suggests that rational inattention may be an important source of information frictions. Second, cognitive limitations also appear to be a source of information frictions: even when information about inflation statistics is made readily available, individuals still place a significant weight on less accurate sources of information, such as their memories of the price changes of the supermarket products they purchase. We discussing the implications of these findings for macroeconomic models and policy-making.

Experimental Tests of Rational Inattention

Mark Dean
,
Columbia University
Nathaniel Neligh
,
Columbia University

Abstract

Recent theoretical work has uncovered the testable predictions of models of rationally inattentive choice, according to which decision makers choose what information to attend to in order to maximize utility from subsequent choices net of information costs. In this paper we introduce a novel experimental framework which allows us to collect the data required for such tests. We show that, in simple settings, subjects behave in a manner which is consistent with a general model of rational inattention. However, behavior deviates in important ways from the predictions of the rational inattention model in which costs are based on the Shannon mutual information between prior and posterior beliefs, as commonly assumed in the applied literature.
Discussant(s)
Laura Veldkamp
,
New York University
Filip Matejka
,
Charles University in Prague and Czech Academy of Sciences
Michael Woodford
,
Columbia University
JEL Classifications
  • C0 - General