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Noisy Memory and Over-Reaction to News

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  • Rava Azeredo da Silveira
  • Michael Woodford

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.

Suggested Citation

  • Rava Azeredo da Silveira & Michael Woodford, 2019. "Noisy Memory and Over-Reaction to News," NBER Working Papers 25478, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:25478
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    References listed on IDEAS

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    1. Thesmar, David & Landier, Augustin & Ma, Yueran, 2017. "New Experimental Evidence on Expectations Formation," CEPR Discussion Papers 12527, C.E.P.R. Discussion Papers.
    2. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-987, December.
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    Cited by:

    1. Timothy Besley & Thiemo Fetzer & Hannes Mueller, 2023. "How Big Is the Media Multiplier? Evidence from Dyadic News Data," CESifo Working Paper Series 10619, CESifo.
    2. Chahrour, Ryan & Jurado, Kyle, 2021. "Optimal foresight," Journal of Monetary Economics, Elsevier, vol. 118(C), pages 245-259.
    3. Galanis, Giorgos & Kollias, Iraklis & Leventidis, Ioanis & Lustenhouwer, Joep, 2022. "Generalizing Heterogeneous Dynamic Heuristic Selection," CRETA Online Discussion Paper Series 73, Centre for Research in Economic Theory and its Applications CRETA.
    4. Caballero, Adrián & López-Pérez, Raúl, 2022. "Heterogeneous primacy and recency effects in frequency estimation," Journal of Economic Behavior & Organization, Elsevier, vol. 200(C), pages 182-203.
    5. Besley, Timothy & Fetzer, Thiemo & Mueller, Hannes, 2019. "Terror and Tourism: The Economic Consequences of Media Coverage," CAGE Online Working Paper Series 449, Competitive Advantage in the Global Economy (CAGE).
    6. Benjamin Enke & Thomas Graeber, 2019. "Cognitive Uncertainty," CESifo Working Paper Series 7971, CESifo.
    7. Chen Lian, 2023. "Mistakes in Future Consumption, High MPCs Now," American Economic Review: Insights, American Economic Association, vol. 5(4), pages 563-581, December.
    8. Neligh, Nathaniel, 2024. "Rational memory with decay," Journal of Economic Behavior & Organization, Elsevier, vol. 223(C), pages 120-145.
    9. Xie, Erhao, 2021. "Empirical properties and identification of adaptive learning models in behavioral game theory," Journal of Economic Behavior & Organization, Elsevier, vol. 191(C), pages 798-821.
    10. Chen Lian, 2021. "Mistakes in Future Consumption, High MPCs Now," NBER Working Papers 29517, National Bureau of Economic Research, Inc.
    11. George-Marios Angeletos & Karthik Sastry, 2019. "Inattentive Economies," NBER Working Papers 26413, National Bureau of Economic Research, Inc.
    12. Galanis, Giorgos & Kollias, Iraklis & Leventidis, Ioanis & Lustenhouwer, Joep, 2022. "Generalizing Heuristic Switching Models," Working Papers 0715, University of Heidelberg, Department of Economics.

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    More about this item

    JEL classification:

    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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