Rational inattention, misallocation, and the aggregate economy

I study the effect of firm managers’ information-processing constraints on production decisions, resource misallocation, and the aggregate economy. Managers have a finite information-processing capacity to reduce uncertainty about firm-specific and economy-wide shocks. The model implies that an increase in aggregate uncertainty leads to reallocation of capacity from learning about firm-specific shocks to learning about aggregate state, leading to higher misallocation of resources and lower output. In contrast, an increase in idiosyncratic uncertainty (through an opposite mechanism) has a non-monotonic effect on aggregate productivity. The model produces new implications regarding the co-movement of inputs and Labor-TFP sensitivity which I confirm empirically.