Yulei Luo | The University of Hong Kong (original) (raw)

Papers by Yulei Luo

Abstract: State-space models have been increasingly used to study macroeconomic and financial pro... more Abstract: State-space models have been increasingly used to study macroeconomic and financial problems. A state-space representation consists of two equations, a measurement equation which links the observed variables to unobserved state variables and a transition equation describing the dynamics of the state variables. In this paper, we show that a classic linear-quadratic macroeconomic framework which incorporates two new assumptions can be analytically solved and explicitly mapped to a state-space representation.

Abstract: In this paper we examine how model uncertainty due to the preference for robustness (RB... more Abstract: In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and the evolution of debt in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB.

Abstract In this paper we examine implications of model uncertainty due to robustness (RB) for co... more Abstract In this paper we examine implications of model uncertainty due to robustness (RB) for consumption, welfare, and aggregate savings under limited information-processing capacity (rational inattention or RI) in an otherwise standard permanent income model with filtering. We first solve the robust permanent income models with inattentive consumers and show that RI by itself creats an additional demand for robustness that leads to higher “induced uncertainty” facing consumers.

Review of Economic Dynamics, Jan 1, 2008

This paper studies how "Rational Inattention" -a kind of information processing constraints propo... more This paper studies how "Rational Inattention" -a kind of information processing constraints proposed by Sims (2003)-affects consumption and saving behavior in a permanent income hypothesis (PIH) model. It is shown that incorporating RI into the otherwise standard PIH model can substantially affect the intertemporal allocation of consumption, which makes the model better explain the data in some important aspects. Specifically, I propose a tractable approach to solve the multivariate state PIH model with RI explicitly and then show that incorporating RI into the model can help resolve the excess sensitivity puzzle and the excess smoothness puzzle in the literature. Furthermore, I find that the utility costs due to RI are very trivial, which can rationalize the key assumption that consumers do not have strong incentive to devote high channel capacity in observing and processing economic information. Finally, I compare the RI hypothesis with the habit formation hypothesis and the rule-of-thumb hypothesis.

Macroeconomic Dynamics, Jan 1, 2009

Standard economic theories of asset markets assume that assets are valued entirely for the consum... more Standard economic theories of asset markets assume that assets are valued entirely for the consumption streams they can finance. This paper examines the introduction of the demand for status (as a function of wealth) into a model of uninsurable idiosyncratic risk -the 'spirit of capitalism' assumption. We find that soc preferences lead to less inequality in wealth;

The BE Journal of Macroeconomics, Jan 1, 2009

This paper introduces the rational inattention hypothesis (RI) -that agents process information s... more This paper introduces the rational inattention hypothesis (RI) -that agents process information subject to finite channel constraints -into a stochastic growth model with permanent technology shocks. We find that RI raises consumption volatility relative to output by introducing an endogenous demand shock. Furthermore, it is shown that incorporating RI can provide an additional internal propagation mechanism (measured by the impulse response function and the autocorrelation function of output growth) and generate higher variance of forecastable movements in output. However, we find that RI cannot resolve these puzzles in the RBC literature -weak internal propagation and low variance of forecastable movements in output, even with what appears to be a very low capacity channel. However, in a model where general equilibrium effects are absent and idiosyncratic shocks cannot be distinguished from aggregate ones, RI has strong propagational effects.

Society for Economic Dynamics, 2005 Meeting Papers, Jan 1, 2005

This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare ... more This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare losses under information processing constraints (it is also called "rational inattention" (RI) in Sims (2003).) in two canonical macroeconomic models: the permanent income hypothesis model (PIH) and the consumption-based capital asset pricing model (CCAPM). It is shown that incorporating RI into these otherwise standard macroeconomic models can provide an additional propagation mechanism and largely affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects.

American Economic Journal: Macroeconomics, Jan 1, 2009

This paper studies the consumption-savings behavior of households who have risk-sensitive prefere... more This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI).

Empirical evidence shows that entrepreneurs hold a large fraction of wealth, have higher saving r... more 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 entrepreneurial risk can substantially affect both the wealth distribution and the macroeconomy.

V The BE Journal of Macroeconomics, Jan 1, 2009

manuscript, University of …, Jan 1, 2007

We study the portfolio decision of an agent with limited information-processing capacity in the s... more We study the portfolio decision of an agent with limited information-processing capacity in the sense of Shannon (1948).

Research Working Paper, Jan 1, 2010

We examine the effects of two types of informational frictions, robustness (RB) and finite inform... more We examine the effects of two types of informational frictions, robustness (RB) and finite 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 fit the data better along these dimensions than the standard model does. for detailed discussions on the difficulties in solving the non-LQ models with these information imperfections. The primary alternative model is based on Mendoza (1991), a small open economy version of a real business cycle model. That model would be significantly less tractable than the one we use, because it involves multiple state variables.

… of Economics, Princeton University, Working Paper, Jan 1, 2001

Review of Economic Dynamics, Jan 1, 2010

This paper explores how the introduction of rational inattention (RI) -that agents process inform... more This paper explores how the introduction of rational inattention (RI) -that agents process information subject to finite channel capacity -affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.

In this paper we examine the implications of two theories of informational frictions, signal extr... more In this paper we examine the implications of two theories of informational frictions, signal extraction (SE) and rational inattention (RI), for optimal decisions and economic dynamics within the linear-quadratic-Gaussian (LQG) setting. We first show that if the variance of the noise and channel capacity are fixed exogenously in the SE and RI problems, respectively, the two environments lead to different policy and welfare implications. We also find that if the signal-to-noise ratio in the SE problem is fixed, the two theories generate the same policy implications in the univariate case, but different policy implications in the multivariate case. These results are robust to the presence of correlation between structural shocks and noise shocks and the presence of risk-sensitive preferences. Thus, while RI provides a microfoundation for the imprecise observations and noise in the SE problem it is difficult to specify the structure of the noise in the SE problem in a manner consistent with the efficiency conditions from RI. JEL Classification Numbers: C61, D81, E21.

Journal of Money, Credit and …, Jan 1, 2009

Recent research has shown that the "spirit of capitalism" -a preference for wealth itself, in add... more Recent research has shown that the "spirit of capitalism" -a preference for wealth itself, in addition to consumption -has important implications for growth and asset pricing. This paper explores how the spirit of capitalism affects saving and consumption behavior. We demonstrate that the spirit of capitalism may reduce the importance of precautionary savings. It can also explain the excess sensitivity puzzle: the spirit of capitalism causes dramatic deviations from a random walk. It may also offer a partial explanation of the excess smoothness puzzle. J y J J c y rw J J a J J y J J a bw J y rw J J a J J J J J J J J J J J y w J Irvine

This paper explores how the introduction of Rational Inattention (RI) a¤ects optimal consumption ... more This paper explores how the introduction of Rational Inattention (RI) a¤ects optimal consumption and portfolio rules and asset pricing in the consumption-based CAPM framework. I …rst solve an otherwise standard portfolio choice and asset pricing model with RI explicitly and show that RI can generate smooth consumption process and low contemporaneous correlation between consumption growth and asset returns. Second, it is shown that in the RI economy asset returns are determined by the ultimate consumption risk rather than the contemporaneous risk. As a result, RI has a potential to reduce the demand for the risky asset and could endogenize "limited stock market participation" hypothesis. Third, I show that RI can disentangle the coe¢ cient of relative risk aversion with the elasticity of intertemporal substitution endogeneously by increasing the e¤ ective CRRA. RI can therefore be an alternative explanation for the equity premium puzzle and the risk free rate puzzle. Fourth, I compare RI with recursive preference, robustness, and habit formation. Fifth, I investigate the implications of RI for optimal consumption and portfolio choice when investment opportunities are stochastic and labor income is modelled explicitly. Finally, I propose a general equilibrium asset pricing framework to examine the implications of RI for the equity premium, the mean ratio of price to dividend, and the equity volatility in equilibrium.

University of Virginia, Jan 1, 2007

Research Working Paper, Jan 1, 2010

In this paper we examine the effects of two types of information imperfections, robustness (RB) a... more In this paper we examine the effects of two types of information imperfections, robustness (RB) and finite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. We then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noise shocks that reduce the correlations.

Abstract: State-space models have been increasingly used to study macroeconomic and financial pro... more Abstract: State-space models have been increasingly used to study macroeconomic and financial problems. A state-space representation consists of two equations, a measurement equation which links the observed variables to unobserved state variables and a transition equation describing the dynamics of the state variables. In this paper, we show that a classic linear-quadratic macroeconomic framework which incorporates two new assumptions can be analytically solved and explicitly mapped to a state-space representation.

Abstract: In this paper we examine how model uncertainty due to the preference for robustness (RB... more Abstract: In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and the evolution of debt in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB.

Abstract In this paper we examine implications of model uncertainty due to robustness (RB) for co... more Abstract In this paper we examine implications of model uncertainty due to robustness (RB) for consumption, welfare, and aggregate savings under limited information-processing capacity (rational inattention or RI) in an otherwise standard permanent income model with filtering. We first solve the robust permanent income models with inattentive consumers and show that RI by itself creats an additional demand for robustness that leads to higher “induced uncertainty” facing consumers.

Review of Economic Dynamics, Jan 1, 2008

This paper studies how "Rational Inattention" -a kind of information processing constraints propo... more This paper studies how "Rational Inattention" -a kind of information processing constraints proposed by Sims (2003)-affects consumption and saving behavior in a permanent income hypothesis (PIH) model. It is shown that incorporating RI into the otherwise standard PIH model can substantially affect the intertemporal allocation of consumption, which makes the model better explain the data in some important aspects. Specifically, I propose a tractable approach to solve the multivariate state PIH model with RI explicitly and then show that incorporating RI into the model can help resolve the excess sensitivity puzzle and the excess smoothness puzzle in the literature. Furthermore, I find that the utility costs due to RI are very trivial, which can rationalize the key assumption that consumers do not have strong incentive to devote high channel capacity in observing and processing economic information. Finally, I compare the RI hypothesis with the habit formation hypothesis and the rule-of-thumb hypothesis.

Macroeconomic Dynamics, Jan 1, 2009

Standard economic theories of asset markets assume that assets are valued entirely for the consum... more Standard economic theories of asset markets assume that assets are valued entirely for the consumption streams they can finance. This paper examines the introduction of the demand for status (as a function of wealth) into a model of uninsurable idiosyncratic risk -the 'spirit of capitalism' assumption. We find that soc preferences lead to less inequality in wealth;

The BE Journal of Macroeconomics, Jan 1, 2009

This paper introduces the rational inattention hypothesis (RI) -that agents process information s... more This paper introduces the rational inattention hypothesis (RI) -that agents process information subject to finite channel constraints -into a stochastic growth model with permanent technology shocks. We find that RI raises consumption volatility relative to output by introducing an endogenous demand shock. Furthermore, it is shown that incorporating RI can provide an additional internal propagation mechanism (measured by the impulse response function and the autocorrelation function of output growth) and generate higher variance of forecastable movements in output. However, we find that RI cannot resolve these puzzles in the RBC literature -weak internal propagation and low variance of forecastable movements in output, even with what appears to be a very low capacity channel. However, in a model where general equilibrium effects are absent and idiosyncratic shocks cannot be distinguished from aggregate ones, RI has strong propagational effects.

Society for Economic Dynamics, 2005 Meeting Papers, Jan 1, 2005

This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare ... more This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare losses under information processing constraints (it is also called "rational inattention" (RI) in Sims (2003).) in two canonical macroeconomic models: the permanent income hypothesis model (PIH) and the consumption-based capital asset pricing model (CCAPM). It is shown that incorporating RI into these otherwise standard macroeconomic models can provide an additional propagation mechanism and largely affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects.

American Economic Journal: Macroeconomics, Jan 1, 2009

This paper studies the consumption-savings behavior of households who have risk-sensitive prefere... more This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI).

Empirical evidence shows that entrepreneurs hold a large fraction of wealth, have higher saving r... more 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 entrepreneurial risk can substantially affect both the wealth distribution and the macroeconomy.

V The BE Journal of Macroeconomics, Jan 1, 2009

manuscript, University of …, Jan 1, 2007

We study the portfolio decision of an agent with limited information-processing capacity in the s... more We study the portfolio decision of an agent with limited information-processing capacity in the sense of Shannon (1948).

Research Working Paper, Jan 1, 2010

We examine the effects of two types of informational frictions, robustness (RB) and finite inform... more We examine the effects of two types of informational frictions, robustness (RB) and finite 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 fit the data better along these dimensions than the standard model does. for detailed discussions on the difficulties in solving the non-LQ models with these information imperfections. The primary alternative model is based on Mendoza (1991), a small open economy version of a real business cycle model. That model would be significantly less tractable than the one we use, because it involves multiple state variables.

… of Economics, Princeton University, Working Paper, Jan 1, 2001

Review of Economic Dynamics, Jan 1, 2010

This paper explores how the introduction of rational inattention (RI) -that agents process inform... more This paper explores how the introduction of rational inattention (RI) -that agents process information subject to finite channel capacity -affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.

In this paper we examine the implications of two theories of informational frictions, signal extr... more In this paper we examine the implications of two theories of informational frictions, signal extraction (SE) and rational inattention (RI), for optimal decisions and economic dynamics within the linear-quadratic-Gaussian (LQG) setting. We first show that if the variance of the noise and channel capacity are fixed exogenously in the SE and RI problems, respectively, the two environments lead to different policy and welfare implications. We also find that if the signal-to-noise ratio in the SE problem is fixed, the two theories generate the same policy implications in the univariate case, but different policy implications in the multivariate case. These results are robust to the presence of correlation between structural shocks and noise shocks and the presence of risk-sensitive preferences. Thus, while RI provides a microfoundation for the imprecise observations and noise in the SE problem it is difficult to specify the structure of the noise in the SE problem in a manner consistent with the efficiency conditions from RI. JEL Classification Numbers: C61, D81, E21.

Journal of Money, Credit and …, Jan 1, 2009

Recent research has shown that the "spirit of capitalism" -a preference for wealth itself, in add... more Recent research has shown that the "spirit of capitalism" -a preference for wealth itself, in addition to consumption -has important implications for growth and asset pricing. This paper explores how the spirit of capitalism affects saving and consumption behavior. We demonstrate that the spirit of capitalism may reduce the importance of precautionary savings. It can also explain the excess sensitivity puzzle: the spirit of capitalism causes dramatic deviations from a random walk. It may also offer a partial explanation of the excess smoothness puzzle. J y J J c y rw J J a J J y J J a bw J y rw J J a J J J J J J J J J J J y w J Irvine

This paper explores how the introduction of Rational Inattention (RI) a¤ects optimal consumption ... more This paper explores how the introduction of Rational Inattention (RI) a¤ects optimal consumption and portfolio rules and asset pricing in the consumption-based CAPM framework. I …rst solve an otherwise standard portfolio choice and asset pricing model with RI explicitly and show that RI can generate smooth consumption process and low contemporaneous correlation between consumption growth and asset returns. Second, it is shown that in the RI economy asset returns are determined by the ultimate consumption risk rather than the contemporaneous risk. As a result, RI has a potential to reduce the demand for the risky asset and could endogenize "limited stock market participation" hypothesis. Third, I show that RI can disentangle the coe¢ cient of relative risk aversion with the elasticity of intertemporal substitution endogeneously by increasing the e¤ ective CRRA. RI can therefore be an alternative explanation for the equity premium puzzle and the risk free rate puzzle. Fourth, I compare RI with recursive preference, robustness, and habit formation. Fifth, I investigate the implications of RI for optimal consumption and portfolio choice when investment opportunities are stochastic and labor income is modelled explicitly. Finally, I propose a general equilibrium asset pricing framework to examine the implications of RI for the equity premium, the mean ratio of price to dividend, and the equity volatility in equilibrium.

University of Virginia, Jan 1, 2007

Research Working Paper, Jan 1, 2010

In this paper we examine the effects of two types of information imperfections, robustness (RB) a... more In this paper we examine the effects of two types of information imperfections, robustness (RB) and finite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. We then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noise shocks that reduce the correlations.