Business cycle dynamics under rational inattention

By Bartosz Maćkowiak and Mirko Wiederholt

http://d.repec.org/n?u=RePEc:ecb:ecbwps:20111331&r=dge

We develop a dynamic stochastic general equilibrium model with rational inattention by households and firms. Consumption responds slowly to interest rate changes because households decide to pay little attention to the real interest rate. Prices respond quickly to some shocks and slowly to other shocks. The mix of fast and slow responses of prices to shocks matches the pattern found in the empirical literature. Changes in the conduct of monetary policy yield very different outcomes than in models currently used at central banks because systematic changes in policy cause reallocation of attention by decision-makers in households and firms.

A lot of interesting papers to choose from this week, and this paper caught my eye because of the premise that agents do not necessarily use all the information. Specifically, they neglect to check on the real interest rate as much as they would under perfect information. In fact, households make a conscious choice, given an estimate of the cost of deviating from the first best. That the impact of monetary policy policy is different from perfect attention models is not surprising, after all the nominal interest rate is the policy tool of the central bank, and households here are inattentive about the real interest rate. What I find particularly interesting is that different shocks have different impacts of the rigidity of prices, something that could help us understand why some prices are more flexible than others.

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