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Authors:

• Mirko WIEDERHOLT
  Northwestern University

• Bartosz MACKOWIAK
  European Central Bank and CEPR

This paper develops a dynamic stochastic general equilibrium model with rational inattention. Decisionmakers have limited attention and choose the optimal allocation of their attention. We study the implications of rational inattention for business cycle dynamics. For example, we study how rational inattention affects the impulse responses of prices and quantities to monetary policy, aggregate technology and micro-level shocks. The impulse responses under rational inattention have several properties of empirical impulse response functions, e.g., (i) prices respond slowly to monetary policy shocks, (ii) prices respond faster to aggregate technology shocks, and (iii) prices respond very fast to disaggregate shocks. In addition, profit losses due to deviations of the actual price from the profit-maximizing price are an order of magnitude smaller than in the Calvo model that generates the same real effects.