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.

Exogenous Information, Endogenous Information, and Optimal Monetary Policy

“…13 The choice of (ξ a , ξ λ ) can be interpreted as the choice of which variable to pay attention to. More precisely, when ρ a = ρ λ = 0 all endogenous variables are just linear functions of a t and λ t and thus equation (81) implies that the price setter in a firm can pay attention to any endogenous variable.…”

“…For the signal structure (81), this is not the case and we have to work with the original equation (20). Thus, in the new model with an endogenous information structure, the Ramsey problem (42)-(60) changes as follows: 13 Adam (2007) …”

Robustly Strategic Consumption–Portfolio Rules with Informational Frictions

“…When ρ = 0, i.e., when labor income follows a Brownian motion, we can compute that σ s = 5. respectively. 31 These figures also show that the higher the value of ϑ, the less the p is. In addition, 30 Caballero (1990) and Wang (2004) also set γ = 2.…”

“…16 Following the state-space-reduction approach proposed in Luo (2008) and using this new state variable, we can rewrite (3) as…”

“…In addition, the state uncertainty considered in this paper is not only from the income process but also from the equity return. Finally, this paper is also related with the work on robust/risk-sensitive/rational inattention permanent income models such as Hansen, Sargent, and Tallarini (1999), Luo (2008), and Luo and Young (2010). The key difference between this paper and the papers mentioned above is that they adopted the linear-quadratic permanent income framework with constant asset returns to study consumption and saving dynamics and did not consider the portfolio choice problem.…”