Consumption dynamics under information processing constraints

Abstract

This paper studies how "rational inattention" (RI)-a type of information processing constraint proposed by Sims [Sims, C.A., 2003. Implications of rational inattention, Journal of Monetary Economics 50 (3), 665-690]-affects the joint dynamics of consumption and income in a permanent income model with general income processes. Specifically, I propose an analytical approach to solve the multivariate permanent income model with RI and examine its implications for optimal consumption, saving, and welfare. It is shown that RI can affect the relative volatility of consumption and provide an endogenous propagation mechanism that disentangles the short-run and long-run responses of consumption to exogenous income shocks. I also explore how aggregation reduces the impact of the RI-induced endogenous noise on consumption and thus increases the smoothness of aggregate consumption. Finally, I compare RI with four alternative hypotheses (habit formation, signal extraction, robustness, and inattentiveness) by examining their implications for the joint behavior of consumption and income. © 2007 Elsevier Inc. All rights reserved.