Risk-sensitive Consumption and Savings under Rational Inattention

Abstract

This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI). We first solve the model explicitly and show that RI increases precautionary savings by interacting with income uncertainty and risk sensitivity. Given the closed-form solutions, we find that the RI model displays a wide range of observational equivalence properties, implying that consumption and savings data cannot distinguish between risk sensitivity, robustness, or the discount factor, in any combination. We then show that the welfare costs from RI are larger for risk-sensitive households than any other observationally-equivalent settings. (JEL D11, D81, D82, E13, E21)