Consumption Dynamics Under Information Processing Constraints
37 Pages Posted: 11 Nov 2008
Date Written: June 1, 2006
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.
Keywords: Rational Inattention, Consumption and Savings Behavior, Short-run and long-run Impacts, Aggregation
JEL Classification: C61, D81, E21
Suggested Citation: Suggested Citation