Processing savings and work decisions through Shannon's channels

This paper argues that constraining people to choose consumption and labor under fi�nite Shannon capacity produces results in line with U.S. business cycle data as well as secular movements in consumption and labor supply. The model has a simple partial equilibrium setting in which risk averse consumers keep high labor supply and low consumption profi�le at early stage of life to hedge against wealth fluctuations. They rationally choose to keep consumption and labor unchanged until they collect enough information. I fi�nd that at high frequency consumption appears to be more sluggish than labor supply. However, when people decide to change consumption they do so by a large amount. This combination leads to higher variance of consumption with respect to labor supply. The model also finds high persistence and strong comovement of consumption and employment and delayed response of consumption and labor with respect to shocks to wages. Positive changes in wages generate an increase in long run value of consumption while the change in long run values of labor is negligible. Furthermore, the effects on labor and consumption of a shock to wages propagate slowly over time due to people's endogenous choice of information. These �findings suggest that rational inattention offers a promising avenue to bridge the gap between theory and U.S. data at business cycle frequency as well as in the long run.