Real Business Cycle Dynamics under Rational Inattention

Abstract

This paper incorporates Rational Inattention as defined by Sims (2003a) to a traditional RBC model with multiple sources of uncertainty. Our model distinguishes between transitory and permanent labor and relative investment productivity shocks. The introduction of information frictions works as an endogenous adjustment cost: given the model parameters, the degree of sluggishness of endogenous variables in response to shocks is optimally determined. In practical terms, Rational Inattention increases the volatility and the contemporaneous correlations with output of consumption and decreases those of investment and hours. Moreover, it generates a trade-off between short-run and long-run shock variances. We believe these effects might have important welfare implications and can provide an analytical understanding on the links between business cycle fluctuations and the long-run performance of an economy