Chapter 4. Rational Inattention and Monetary Economics

Rational inattention theory is economic theory that recognizes that people have finite information-processing capacity, in the sense of Shannon and engineering information theory. This approach is still in the early stages of development, but it promises to provide a unified explanation for some of the frictions and delays that are important in dynamic macroeconomics and finance. In this chapter we introduce the basic ideas of information theory, show how it can be introduced formally into dynamic optimization problems, discuss existing applications of the approach, and indicate some of its implications for macroeconomic modeling and monetary policy.