Information Choice in Macroeconomics and Finance Information Choice in Macroeconomics and Finance Laura L. Veldkamp Copyright © 2011 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW press.princeton.edu All Rights Reserved Library of Congress Cataloging-in-Publication Data Veldkamp, Laura. Information choice in macroeconomics and finance / Laura L. Veldkamp. p. cm. Includes bibliographical references and index. ISBN 978-0-691-14220-3 (alk. paper) 1. Macroeconomics–Decision making. 2. Finance–Decision making. 3. Information resources. 4. Choice (Psychology) I. Title. HB172.5.V45 2011 339.5–dc22 2011010183 British Library Cataloging-in-Publication Data is available This book has been composed in Times Printed on acid-free paper. ∞ Typeset by S R Nova Pvt Ltd, Bangalore, India Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 Contents Acknowledgments PART I PRELIMINARIES Chapter 1 Why Study Information Choice? 1.1 Types of Learning Models 1.2 Themes That Run through the Book 1.3 Organization of the Book Chapter 2 Bayesian Updating 2.1 Normal Random Variables 2.2 Uniform Random Variables 2.3 The Kalman Filter 2.4 Bayesian Updating in Continuous Time 2.5 Mathematical References 2.6 Exercises Chapter 3 Measuring Information Flows 3.1 Preliminaries 3.2 Entropy and Rational Inattention 3.3 Additive Cost in Signal Precision 3.4 Diminishing Returns to Learning and Unlearnable Risk 3.5 Inattentiveness 3.6 Recognition 3.7 Information-Processing Frictions 3.8 Learning When Outcomes Are Correlated 3.9 What Is the Right Learning Technology? 3.10 Appendix: Matrix Algebra and Eigen-Decompositions 3.11 Exercises Chapter 4 Games with Heterogeneous Information 4.1 Preliminary Concepts 4.2 Heterogeneous Information Eliminates Multiple Equilibria 4.3 Information and Covariance: A Beauty Contest Model 4.4 Strategic Motives in Information Acquisition 4.5 Example: Information Choice and Real Investment 4.6 Public Information Acquisition and Multiple Equilibria 4.7 Broader Themes and Related Literature 4.8 Exercises PART II INFORMATION CHOICE WITH COMPLEMENTARITY IN ACTIONS Chapter 5 Disclosing Public Information 5.1 Payoff Externalities and the Social Value of Information 5.1.1 Coordination and Overreaction to Public Information 5.1.2 Morris and Shin’s Social Cost of Public Information 5.1.3 Can Private Information Also Be Socially Costly? 5.1.4 A More General Approach 5.1.5 The Central Bank Transparency Debate 5.2 Public Information Crowds Out Private Information 5.2.1 Amador and Weill 2009 5.2.2 Complementary Public and Private Information 5.2.3 Private Information Makes Public Disclosures More Informative 5.3 More Information Increases Price Volatility 5.4 Public Information Makes Money Neutral 5.5 Broader Themes and Paths for Future Research 5.5.1 Speculative Currency Attacks 5.5.2 A Coordination-Based Theory of Leadership 5.6 Exercises Chapter 6 Informational Inertia and Price-Setting 6.1 Lucas-Phelps Model 6.2 A Recipe for Inertia 6.3 Inattentiveness in Price-Setting 6.4 Rational Inattention Models of Price-Setting 6.5 Are Prices State Dependent or Time Dependent? 6.6 Broader Themes and Paths for Future Research 6.7 Exercises PART III INFORMATION CHOICE WITH SUBSTITUTABILITY IN ACTIONS Chapter 7 Information Choice and Investment Choice 7.1 A One-Asset Model with Information Choice 7.2 Multiple Assets and Exogenous Information 7.3 Multiple Assets with Information Choice 7.3.1 Gains to Specialization 7.3.2 Identical Investors Hold Different Portfolios 7.4 Interpreting Information Constraints in Equilibrium 7.5 Broader Themes and Paths for Future Research 7.6 Appendix: Computing Expected Utility 7.7 Appendix: Correlated Assets 7.8 Exercises Chapter 8 Returns to Scale in Information 8.1 Returns to Scale in Real Investment (One Asset) 8.2 Gains to Specialization (N Assets) 8.2.1 Result: Optimal Portfolio Choice 8.2.2 Result: Optimal Information Choice 8.2.3 Indifference Results 8.2.4 Preference for Early Resolution of Uncertainty 8.3 Markets for Information 8.4 Broader Themes 8.5 Paths for Future Research 8.6 Exercises Chapter 9 Information as an Aggregate Shock 9.1 News about Future Productivity 9.1.1 Model 1: Cross-Industry Complementarity 9.1.2 Model 2: Gradual Capital Adjustment 9.1.3 Matching Stock Market Fluctuations 9.1.4 Empirical Evidence on News Shocks 9.2 News about Current Productivity 9.2.1 Model 3: Aggregate News Shocks 9.2.2 Model 4: Confusing Private and Public News 9.3 Broader Themes and Paths for Future Research 9.4 Exercises PART IV MEASUREMENT Chapter 10 Testing Information Theories 10.1 Measuring Flows of News 10.2 Forecast Precision 10.3 Using Covariances to Infer Information Sets 10.4 Realized Profits as Proxies for Information 10.5 Information Choice as a Substitute for Information Data 10.6 The Bid-Ask Spread and PIN Chapter 11 Conclusions References Index Acknowledgments While working on this book, I received constructive suggestions and comments from many people. The book grew out of a set of notes that I had prepared for a Ph.D. symposium held at Humboldt University in Berlin and later expanded for a Ph.D. topics class in macroeconomics at New York University. The students in both classes read through drafts of the book and provided me with enormously useful feedback. In addition, many colleagues and economists at other schools provided their input. In particular, I am grateful to Manuel Amador, Cosmin Ilut, Peter Kondor, Pierre-Olivier Weill, Mirko Wiederholt, and two anonymous reviewers for extensive comments. Anna Orlik provided invaluable editing and proofreading assistance and helped formulate and solve many of the exercises. Of course, I retain responsibility for any remaining errors. I appreciate being notified of errata. Please email comments to [email protected]. I will try to maintain a list of corrections on my homepage. Last, but not least, I am indebted to my husband, Stijn Van Nieuwerburgh, for encouraging me to undertake and complete this project. Information Choice in Macroeconomics and Finance