Robust control, informational frictions, and international consumption correlations

Abstract

In this paper we examine the effects of model misspecification (robustness or RB) on international consumption correlations in two otherwise standard small open economy models: one with perfect state observation and the other with imperfect state observation. 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 with perfect state observation cannot explain the observed consumption correlations quantitatively. We then show that the RB model with imperfect state observation is capable of matching the behavior of international consumption * We would like to thank

Robustness, information–processing constraints, and the current account in small open economies

“…The model proposed in this paper can also be used to address the international diversification and consumption correlations puzzles (Backus et al, 1992). In Luo et al (2011) we show that the model incorporating model uncertainty and state uncertainty reduces the correlation of consumption across countries, and can in fact produce consumption correlations lower than income correlations. RB will lower the international consumption correlations by generating heterogenous responses of consumption to income shocks across countries, provided countries differ in terms of their preference for robustness.…”

“…(42) and (43), we can see that imperfect state observation due to RI can amplify the importance of model uncertainty measured by Σ in determining consumption and precautionary savings. Before proceeding, we want to draw a distinction between the model proposed above and similar ones used in Luo and Young (2010) and Luo et al (2011). In those other papers, agents were assumed to trust the Kalman filter they use to process information, meaning that decisions were only robust to misspecification of the income process.…”

The Role of Transitory and Persistent Shocks in the Consumption Correlation and International Comovement Puzzles

“…More recently, studies have focused on an individual's behavior incorporated into novel models. For example, Fuhrer and Klein (2006) illuminate households' habit formation and Luo et al (2010) examine imperfect information models, "robustness" [Hansen and Sargent (2008)], and "rational inattention" [Sims (2003)] and then show that "rational inattention" can explain the observed data.…”