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Consumption Dynamics under Information Processing Constraints

  • Yulei Luo

    (Princeton University)

This paper studies consumption dynamics and welfare losses under information processing constraints (it is also called 'rational inattention' (RI) in Sims (2003)) in the permanent income hypothesis (PIH) model. It is shown that incorporating RI into the otherwise standard PIH model can substantially affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects. Specifically, the main contributions of this paper are: first, we propose a tractable analytical approach to solve the multivariate state PIH model with RI and show that consumption reacts to the shocks to wealth gradually and with delay; second, after aggregating, we show that incorporating RI into the model can help resolve the excess sensitivity puzzle and the excess smoothness puzzle; third, we also find that the utility costs due to RI are very trivial, which can rationalize a key assumption in Sims (2003) that consumers only devote low channel capacity in observing and processing information; fourth, we investigate which factors determine optimal channel capacity endogeneously; finally, we compare our RI model with the standard internal habit formation model and the Campbell-Mankiw's rule-of-thumb model.

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File URL: http://econwpa.repec.org/eps/mac/papers/0505/0505011.pdf
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Paper provided by EconWPA in its series Macroeconomics with number 0505011.

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Length: 41 pages
Date of creation: 13 May 2005
Date of revision: 03 Jun 2005
Handle: RePEc:wpa:wuwpma:0505011
Note: Type of Document - pdf; pages: 41
Contact details of provider: Web page: http://econwpa.repec.org

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  1. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
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  4. Bartosz Mackowiak & Mirko Wiederholt, 2004. "Optimal Sticky Prices under Rational Inattention," SFB 649 Discussion Papers SFB649DP2005-040, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany, revised Jul 2005.
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