Signal Extraction and Rational Inattention

19 Pages Posted: 26 Feb 2014

See all articles by Yulei Luo

Yulei Luo

University of Hong Kong

Eric R. Young

University of Virginia

Date Written: April 2014


In this paper we examine the implications of two theories of informational frictions, signal extraction (SE) and rational inattention (RI), for optimal decisions and economic dynamics within the linear‐quadratic‐Gaussian (LQG) setting. We first show that if the variance of the noise and channel capacity (or marginal information cost) is fixed exogenously in the SE and RI problems, respectively, the two environments lead to different policy and equilibrium asset pricing implications. Second, we find that if the signal‐to‐noise ratio and capacity in the SE and RI problems are fixed, respectively, the two theories generate the same policy implications in the univariate case, but different policy implications in the multivariate case. We also show that our results do not depend on the presence of correlation between fundamental and noise shocks. We then discuss the applications to macroeconomic models of permanent income and price‐setting.

JEL Classification: C61, D81, E21

Suggested Citation

Luo, Yulei and Young, Eric R., Signal Extraction and Rational Inattention (April 2014). Economic Inquiry, Vol. 52, Issue 2, pp. 811-829, 2014. Available at SSRN: or

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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