Ebook Business Cycle Dynamics under Rational Inattention
Economists have studied for a long time how decision-makers allocate scarce resources. The recent literature on rational inattention studies how decision makers allocate the scarce resource attention. The idea is that decision makers have limited attention and decide how to allocate their attention. This paper develops a dynamic stochastic general equilibrium (DSGE) model with rational inattention. Decision-makers in firms and households have limited attention and decide how to allocate their attention. Following Sims (2003), we model attention as an information flow and we model limited attention as a constraint on information flow. As an example, consider a household that decides how much to consume and which goods to consume. To take the optimal consumption saving decision and to buy the optimal consumption basket, the household has to know the real interest rate and the prices of all consumption goods. The idea of rational inattention applied to this example is that knowing the real interest rate and the prices of all consumption goods requires attention, households have limited attention, and households decide how to allocate their attention. We study the implications of rational inattention for business cycle dynamics.
We are motivated by the question of how to model the inertia found in macroeconomic data. Standard DSGE models used for policy analysis match this inertia by introducing multiple sources of slow adjustment: Calvo price setting, habit formation in consumption, Calvo wage setting, and other sources in richer models. We pursue the alternative idea that the inertia found in macroeconomic data can be understood as the result of rational inattention by decision-makers.
We model an economy with many firms, many households, and a government. Firms produce differentiated goods with a variety of types of labor. Households supply the differentiated types of labor, consume the different goods, and hold nominal government bonds. Decision-makers in firms take price setting and factor mix decisions. Households take consumption and wage setting decisions. The central bank sets the nominal interest rate according to a Taylor rule. The economy is affected by aggregate technology shocks, monetary policy shocks, and firm-specific productivity shocks. The only source of slow adjustment to shocks is rational inattention by decision-makers.
We summarize the model’s predictions in four points. The first prediction of the model is that prices respond rapidly to market-specific shocks, fairly quickly to aggregate technology shocks, and slowly to monetary policy shocks. We first solve the model assuming rational inattention by decision-makers in firms and perfect information on the side of households to isolate the implications of rational inattention by decision-makers in firms. We find that: (i) prices respond very quickly to market-specific shocks, (ii) the price level responds fairly quickly to aggregate technology shocks, and (iii) the price level responds slowly to monetary policy shocks. The reason for this combination of fast and slow adjustment of prices to shocks is that decision makers in firms decide to pay a lot of attention to market-specific conditions, quite a bit of attention to aggregate technology, and little attention to monetary policy. The empirical literature finds in the data the same pattern of fast and slow responses of prices to shocks. This pattern of fast and slow adjustment of prices to shocks is difficult to match with DSGE models that are commonly used for monetary policy analysis (e.g., the Calvo model or the sticky information model of Mankiw and Reis (2002)).
In our model and in any other model with a price setting friction, firms experience profit losses due to deviations of the price from the profit maximizing price. An important feature of our model is that these profit losses are small. For comparison, in our benchmark economy profit losses due to deviations of the price from the profit-maximizing price are 30 times smaller than in the Calvo model that generates the same real effects of monetary policy shocks. The main reason is that in our model prices respond slowly to monetary policy shocks but fairly quickly to aggregate technology shocks and rapidly to market-specific shocks. By contrast, in the Calvo model prices respond slowly to all shocks. The other reason is that under rational inattention deviations of the price from the profit-maximizing price are less likely to be extreme than in the Calvo model.
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