Abhatoo - Centre Nationale de Documentation

This paper studies how “Rational Inattention” - a kind of information processing constraints proposed by Sims (2003)- affects consumption and saving behavior in a 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 model better explain the data in some important aspects. Specifically, I propose a tractable approach to solve the multivariate state PIH model with RI explicitly and then show that incorporating RI into the model can help resolve the excess sensitivity puzzle and the excess smoothness puzzle in the literature. Furthermore, I find that the utility costs due to RI are very trivial, which can rationalize the key assumption that consumers do not have strong incentive to devote high channel capacity in observing and processing economic information. Finally, I compare the RI hypothesis with the habit formation hypothesis and the rule-of-thumb hypothesis.