TY - JOUR AU - da Silveira, Rava Azeredo AU - Woodford, Michael TI - Noisy Memory and Over-Reaction to News JF - National Bureau of Economic Research Working Paper Series VL - No. 25478 PY - 2019 Y2 - January 2019 DO - 10.3386/w25478 UR - http://www.nber.org/papers/w25478 L1 - http://www.nber.org/papers/w25478.pdf N1 - Author contact info: Rava Azeredo da Silveira Département de Physique Ecole Normale Supérieure 24 rue Lhomond 75005 Paris France E-Mail: rava@ens.fr Michael Woodford Department of Economics Columbia University 420 W. 118th Street New York, NY 10027 Tel: 212/854-1094 Fax: 212-854-8059 E-Mail: mw2230@columbia.edu AB - 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. ER -