Abstract: This paper argues that constraining people to choose consumption and labor under finite Shannon capacity produces results in line with U.S. business cycle data. My model has a simple partial equilibrium setting in which risk averse consumers keep high labor supply and low consumption profile 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 find 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. My model also finds high persistence and strong comovement of consumption and employment and delayed response of consumption and labor with respect to wealth. Furthermore, my framework generates endogenously a wedge between marginal rate of substituition and marginal rate of transformation or wages. Such wedge is bigger and more volatile the lower information flow. These findings suggest that rational inattention offers a promising avenue to bridge the gap between theory and U.S. business cycle data.
Keywords: Rational inattention, savings, labor, decisionmakingFull paper (433 KB PDF) | Full paper (Screen Reader Version)