Rational Inattention and Aggregate Fluctuations

51 Pages Posted: 1 Jun 2006 Last revised: 10 Nov 2008

See all articles by Yulei Luo

Yulei Luo

University of Hong Kong

Eric R. Young

University of Virginia

Date Written: April 1, 2006

Abstract

This paper introduces the rational inattention hypothesis (RI) -- that agents process information subject to finite channel constraints -- into a stochastic growth model with permanent technology shocks. We find that RI raises consumption volatility relative to output by introducing an endogenous demand shock. Furthermore, it is shown that incorporating RI can provide an additional internal propagation mechanism (measured by the impulse response function and the autocorrelation function of output growth) and generate higher variance of forecastable movements in output. However, we find that RI cannot resolve these puzzles in the RBC literature -- weak internal propagation and low variance of forecastable movements in output, even with what appears to be a very low capacity channel.

Keywords: Rational Inattention, Consumption Volatility, Propagation Mechanism

JEL Classification: E13, E21, E32, G12

Suggested Citation

Luo, Yulei and Young, Eric R., Rational Inattention and Aggregate Fluctuations (April 1, 2006). Available at SSRN: https://ssrn.com/abstract=905345 or http://dx.doi.org/10.2139/ssrn.905345

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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