“Consumption Dynamics and Asset Pricing under Information Processing Constraints” by Yulei LUO
This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare losses under information processing constraints (it is also called "rational inattention" (RI) in Sims (2003).) in two canonical macroeconomic models: the permanent income hypothesis model (PIH) and the consumption-based capital asset pricing model (CCAPM). It is shown that incorporating RI into these otherwise standard macroeconomic models can provide an additional propagation mechanism and substantially affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects. The main contributions of this paper are: first, we propose a tractable analytical approach to solve the multivariate LQ or approximate LQ models with information constraints; second, given the closed-form solutions, we address a variety of the consumption and asset pricing puzzles, and show how incorporating RI may resolve these puzzles in the correct direction; third, we find that the utility costs due to deviating from the first best instantly adjusted path are very trivial, which can rationalize a key assumption in Sims (2003) that consumers only devote small fractions of their capacity in observing and processing information; finally, we compare our RI model with the standard internal habit formation model. In addition, we consider the extension to the risk-sensitive PIH model, in which the risk-sensitive preference combined with labor income uncertainty generates precautionary savings motive and then allows us to examine the effects of RI on both precautionary savings and the marginal propensity to consume out of income.