The rigidity of choice: lifetime savings under information-processing constraints

This paper studies the implications of information-processing limits on the consumption and savings behavior of households through time. It presents a dynamic model in which consumers rationally choose the size and scope of the information they want to process about their fi�nancial possibilities, constrained by a Shannon channel. The model predicts that people with higher degrees of risk aversion rationally choose higher information. This happens for precautionary reasons since, with fi�nite processing rate, risk averse consumers prefer to be well informed about their fi�nancial possibilities before implementing consumption plan. Moreover, numerical results show that consumers with processing capacity constraints have asymmetric responses to shocks, with negative shocks producing more persistent effects than positive ones. This asymmetry results into more savings. I show that the predictions of the model can be effectively used to study the impact of tax reforms on consumers spending. The results are qualitatively consistent with the evidence on tax rebates (2001, 2008).Consumption, Rational Inattention, Dynamic programming

'Rational inattention' guides overloaded brains, helps economists understand market behavior

Between Internet news sources, social media and email, people are awash in information, most of it accessible at near-zero cost. Yet, humans possess only a finite capacity to process all of it. The average email user, for example, receives dozens of messages per day. The messages can’t all receive equal attention. How carefully does someone read an email from a sibling or friend before crafting a reply? How closely does a person read an email from the boss?> ; Limitations on the ability to process information force people to make choices regarding the subjects to which they pay more or less attention. Economists have long acknowledged the existence of human cognitive capacities, but only in recent years have models embodying such limits known as “rational inattention” found their way into mainstream macroeconomics.> ; Rational inattention models have a broad range of applications. They may reconcile relatively unchanged prices and volatile ones and how the two play out in aggregate demand in the U.S. economy. Moreover, such models can capture salient features of the business cycle, providing a rationale for sharp contractions or slower expansions. Finally, rational inattention models have significant implications for monetary policy. Since the focus of these models revolves around formation of peoples’ expectations, understanding how individuals perceive the economy is instrumental to policymakers’ efforts to achieve output and price stabilization objectives.Information technology ; Macroeconomics - Econometric models ; Business cycles

Rationally inattentive macroeconomic wedges

This paper argues that the solution to a dynamic optimization problem of consumption and labor under finite information-processing capacity can simultaneously explain the intertemporal and intratemporal labor wedges. It presents a partial equilibrium model, where a representative risk adverse consumer chooses information about wealth with limited attention. The paper compares ex-post realizations of models with finite and infinite capacity. The model produces macroeconomic wedges and measures of elasticity consistent with the literature. These findings suggest that a consumption-labor model with information-processing constraints can explain the difference between predicted and observed consumption and employment behavior.Consumption (Economics) ; Labor market ; Econometric models ; Consumer behavior

Processing savings and work decisions through Shannon's channels

This paper argues that constraining people to choose consumption and labor under fi�nite Shannon capacity produces results in line with U.S. business cycle data as well as secular movements in consumption and labor supply. The model has a simple partial equilibrium setting in which risk averse consumers keep high labor supply and low consumption profi�le 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 fi�nd 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. The model also finds high persistence and strong comovement of consumption and employment and delayed response of consumption and labor with respect to shocks to wages. Positive changes in wages generate an increase in long run value of consumption while the change in long run values of labor is negligible. Furthermore, the effects on labor and consumption of a shock to wages propagate slowly over time due to people's endogenous choice of information. These �findings suggest that rational inattention offers a promising avenue to bridge the gap between theory and U.S. data at business cycle frequency as well as in the long run.Savings and labor decisions, Shannon capacity, US business cycle

Experimental evidence on rational inattention

We show that rational inattention theory of Sims (2003) provides a rationalization of choice models à la Luce and gives a structural interpretation to probability curvature parameters as reflecting costs of processing information. We use data from a behavioral experiment to show that people behave according to predictions of the theory. We estimate attitudes to risk and costs of information for individual participants and document overwhelming heterogeneity in these parameters among a relatively homogeneous sample of people. We characterize, both theoretically and empirically, the aggregation biases this heterogeneity implies and find these biases to be substantial.Risk management ; Econometrics

The rigidity of choice: lifetime savings under information-processing constraints

This paper studies the implications of information-processing limits on the consumption and savings behavior of households through time. It presents a dynamic model in which consumers rationally choose the size and scope of the information they want to process about their fi�nancial possibilities, constrained by a Shannon channel. The model predicts that people with higher degrees of risk aversion rationally choose higher information. This happens for precautionary reasons since, with fi�nite processing rate, risk averse consumers prefer to be well informed about their fi�nancial possibilities before implementing consumption plan. Moreover, numerical results show that consumers with processing capacity constraints have asymmetric responses to shocks, with negative shocks producing more persistent effects than positive ones. This asymmetry results into more savings. I show that the predictions of the model can be effectively used to study the impact of tax reforms on consumers spending. The results are qualitatively consistent with the evidence on tax rebates (2001, 2008)

Processing savings and work decisions through Shannon's channels

This paper argues that constraining people to choose consumption and labor under fi�nite Shannon capacity produces results in line with U.S. business cycle data as well as secular movements in consumption and labor supply. The model has a simple partial equilibrium setting in which risk averse consumers keep high labor supply and low consumption profi�le 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 fi�nd 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. The model also finds high persistence and strong comovement of consumption and employment and delayed response of consumption and labor with respect to shocks to wages. Positive changes in wages generate an increase in long run value of consumption while the change in long run values of labor is negligible. Furthermore, the effects on labor and consumption of a shock to wages propagate slowly over time due to people's endogenous choice of information. These �findings suggest that rational inattention offers a promising avenue to bridge the gap between theory and U.S. data at business cycle frequency as well as in the long run

The rigidity of choice: lifetime savings under information-processing constraints

This paper studies the implications of information-processing limits on the consumption and savings behavior of households through time. It presents a dynamic model in which consumers rationally choose the size and scope of the information they want to process about their fi�nancial possibilities, constrained by a Shannon channel. The model predicts that people with higher degrees of risk aversion rationally choose higher information. This happens for precautionary reasons since, with fi�nite processing rate, risk averse consumers prefer to be well informed about their fi�nancial possibilities before implementing consumption plan. Moreover, numerical results show that consumers with processing capacity constraints have asymmetric responses to shocks, with negative shocks producing more persistent effects than positive ones. This asymmetry results into more savings. I show that the predictions of the model can be effectively used to study the impact of tax reforms on consumers spending. The results are qualitatively consistent with the evidence on tax rebates (2001, 2008)

Processing savings and work decisions through Shannon's channels

This paper argues that constraining people to choose consumption and labor under fi�nite Shannon capacity produces results in line with U.S. business cycle data as well as secular movements in consumption and labor supply. The model has a simple partial equilibrium setting in which risk averse consumers keep high labor supply and low consumption profi�le 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 fi�nd 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. The model also finds high persistence and strong comovement of consumption and employment and delayed response of consumption and labor with respect to shocks to wages. Positive changes in wages generate an increase in long run value of consumption while the change in long run values of labor is negligible. Furthermore, the effects on labor and consumption of a shock to wages propagate slowly over time due to people's endogenous choice of information. These �findings suggest that rational inattention offers a promising avenue to bridge the gap between theory and U.S. data at business cycle frequency as well as in the long run

Rationally Inattentive Savers and Monetary Policy Changes: A Laboratory Experiment

We study the response of consumption and saving decisions of rationally inattentive individuals to changes in monetary policy in the laboratory. First, we theoretically characterize the choices of a rationally inattentive agent processing information about the interest rate. Then, we design an experiment with induced inattention to test for the predictions of the model, contrasting them to the full information case. Consistent with the predictions, experimental subjects (a) increase attention when utility gains exceed cognitive costs of tracking the policy rate and decrease savings when their perceived economic outlook deteriorates; (b) respond to Delphic, but not Odyssean, forms of forward guidance. These findings agree with recent empirical evidence on monetary policy effects on consumption behavior in U.S. and internationally