Attention Allocation and Heterogenous Consumption Responses

Recessions often have detrimental effects on both employment and equity returns, forcing individuals to make decisions about how to balance risks to their labor and capital income. In this paper, we study how individuals allocate their limited attention between capital income and labor income risks in a two-period consumption-saving model with recursive utility. Specifically, we examine how the optimal attention and consumption-saving decisions are influenced by individuals’ attention capacity, wealth endowments, income risks, and preferences for risk and time. We show that our model can generate results that are consistent with several novel facts regarding how differences in individuals’ wealth levels and beliefs about their unemployment risks influenced their consumption during the Great Recession. Furthermore, we find that the welfare loss due to limited attention is significantly larger for households with lower wealth; allowing these households to flexibly allocate their attention can significantly reduce this welfare loss.