Business Cycle Dynamics under Rational Inattention

Abstract

We develop a dynamic stochastic general equilibrium (DSGE) model with rational inattention and compare its predictions to data. Households and decision-makers in firms have limited attention and optimally allocate their attention. Rational inattention is the only source of slow adjustment. The model matches the empirical impulse responses to monetary policy shocks and aggregate technology shocks. At the same time, profit losses and utility losses from inattention are very small. Furthermore, it matters whether one uses this model or a conventional DSGE model for policy analysis.