Noisy Memory and Over-Reaction to News
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.
We thank Yeji Sung for research assistance, and Ben Hebert, David Laibson, Yueran Ma and Andrei Shleifer for helpful discussions. Azeredo da Silveira gratefully acknowledges research support from the CNRS through UMR 8550. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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. citation courtesy of