Sparse Boundedly Rational Dynamic Programming and Aggregate Fluctuations

Abstract

This paper proposes a way to model boundedly rational dynamic programming in a parsimonious and tractable way. It first illustrates the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. This helps resolve some extant puzzles in consumption behavior, especially the tenuous link between interest rates and consumption. The paper then lays out the general formulation of behavioral dynamic program- ming, and derives tools that make it generally quite easy to compute, even with paper and pencil. It also presents an application to dynamic portfolio choice, arguing that the description put forth by the model is more realistic that in the standard, fully rational model. Finally, it studies in a basic case the impact of bounded rationality (as modeled in this paper) on macroeconomic outcomes, in a prototypical DSGE model with one variable, capital. We find that in general equilibrium, bounded rationality leads to more persistent shocks, and larger aggregate fluctuations.