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Noisy Memory and Over-Reaction to News

Rava Azeredo da Silveira and Michael Woodford ()

No 25478, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We propose a model of optimal decision making subject to a memory constraint. The constraint is a limit on the complexity of memory measured using Shannon’s mutual information, as in models of rational inattention; but our theory differs from that of Sims (2003) in not assuming costless memory of past cognitive states. We show that the model implies that both forecasts and actions will exhibit idiosyncratic random variation; that beliefs will fluctuate forever around the rational-expectations (perfect-memory) beliefs with a variance that does not fall to zero; and that more recent news will be given disproportionate weight. The model provides a simple explanation for a number of features of expectations in laboratory and field settings, most notably apparent over-reaction of both elicited forecasts and spending decisions to transitory fluctuations in economic time series.

JEL-codes: D91 E71 G41 (search for similar items in EconPapers)
Date: 2019-01
New Economics Papers: this item is included in nep-mic and nep-upt
Note: EFG ME
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Published as Rava Azeredo da Silveira & Michael Woodford, 2019. "Noisy Memory and Over-Reaction to News," AEA Papers and Proceedings, American Economic Association, vol. 109, pages 557-561, May.

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