Consumption Dynamics Under Information Processing Constraints

Abstract

This paper studies how "rational inattention (RI)"-a type of information processing constraint proposed by Sims (2003)-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.

Robustness, information–processing constraints, and the current account in small open economies

“…15 See Sims (2003) and Luo (2008). 16 Habit formation also worsens the model's predictions on the current account dynamics; consumption adjusts slowly with respect to income shocks under habit formation, as shown in Gruber (2004), generating procyclical current accounts.…”

“…16 Habit formation also worsens the model's predictions on the current account dynamics; consumption adjusts slowly with respect to income shocks under habit formation, as shown in Gruber (2004), generating procyclical current accounts. Luo (2008) compares the consumption predictions of habit formation and RI. 17 The annual data comes from World Development Indicators and the included countries and their sample periods are as follows.…”

“…One key change relative to the RE case is that consumption has a humpshaped impulse response to changes in income. 15 Using the results in Luo (2008), it is straightforward to show that RI by itself still leads to counterfactual strongly-procyclical current accounts and cannot generate precautionary savings in the LQG setting. 16 However, the combination of RB and RI produces a model that captures many of the facts that are seen as anomalous through the lens of an RE model, while producing consumption dynamics that are consistent with the data.…”

Rational Inattention and Choice Under Risk: Explaining Violations of Expected Utility Through a Shannon Entropy Formulation of the Costs of Rationality

“…Woodford (2007) is an application of Sims's idea to the field of price-changing behavior. Work on generalizing Sims (2006) to a wider intertemporal choice setting is being done by Luo (2006).…”

Transitional Dynamics in Sticky-Information General Equilibrium Models

“…The most influent strand of literature in this context concerns the notion of rational inattention (see, e.g., Sims 2003;Luo 2008;Mankiw and Wiederholt 2009). Under rational inattention, the central problem is not related to costs of information acquisition but rather with the choice agents make about the information they prefer to be attentive to.…”