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.