123 Pages Posted: 14 May 2020 Last revised: 6 Sep 2023
Date Written: September 1, 2023
We study how the extent of bounded rationality evolves with the state of the economy. We introduce a business-cycle model in which firms face a cognitive cost of making precise decisions and decide how much to "pay attention" to specific states. We analytically characterize equilibrium with non-parametric, state-dependent stochastic choice and nonlinear aggregation and dynamics. Firms have greater incentives to direct attention toward states of lower aggregate consumption because they are owned by risk-averse households. This mechanism generates counter-cyclical attention, pro-cyclical mistakes, and an endogenous attention wedge that depresses aggregate productivity when attention is low. We test and validate these macroeconomic predictions and our proposed microeconomic mechanism using novel measures of US public firms' input-choice mistakes and a textual proxy for their attention toward macroeconomic conditions. When calibrated to match our measurements, attention cycles generate a significant fraction of the observed stochastic volatility of output growth and shock propagation asymmetries.
Keywords: Business Cycles, Attention, Bounded Rationality, Shock Propagation, Volatility
JEL Classification: E32, E44, E71, D83
Suggested Citation: Suggested Citation