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Authors:

• Yulei LUO
  The University of Hong Kong

• Eric R. YOUNG
  University of Virginia

This paper studies the implications of limited information-processing capacity (rational inattention) for optimal consumption and precautionary savings in a permanent income hypotheis (PIH) model with risk-sensitive consumers. Specifically, we derive the explicit solution of this model and examine how rational inattention (RI) affects the marginal propensity of consumption (MPC) and precautionary savings as well as the joint dynamics of consumption and income. We show that (1) RI decreases the MPC out of permanent income, (2) RI raises the amount of precautionary savings on average, and (3) incorporating RI into the RS PIH model can make the model better explain the observed joint dynamics of aggregate consumption and income. We also discuss the welfare effects of the interplay between RI and RS.