Discussion Paper Details

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Title: Business Cycle Dynamics under Rational Inattention

Author(s): Bartosz Adam Mackowiak and Mirko Wiederholt

Publication Date: February 2010

Keyword(s): Business Cycles, Dynamic Stochastic General Equilibrium, Information Choice, Monetary Policy and Rational Inattention

Programme Area(s): International Macroeconomics

Abstract: This paper develops a dynamic stochastic general equilibrium model with rational inattention. Households and decision-makers in firms have limited attention and decide how to allocate their attention. The paper studies the implications of rational inattention for business cycle dynamics. Impulse responses in the model have several properties of empirical impulse responses. Prices respond slowly to monetary policy shocks, faster to aggregate TFP shocks, and very quickly to disaggregate shocks. Therefore, profit losses due to deviations of the actual price from the profit-maximizing price are an order of magnitude smaller than in the Calvo model that generates the same real effects. Consumption responds slowly to aggregate shocks. For standard parameter values, deviations from the consumption Euler equation are cheap in utility terms, implying that households devote little attention to the consumption-saving decision and react slowly to changes in the real interest rate.

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Bibliographic Reference

Mackowiak, B and Wiederholt, M. 2010. 'Business Cycle Dynamics under Rational Inattention'. London, Centre for Economic Policy Research.