Rational Inattention and Dynamics of Consumption and Wealth in General Equilibrium

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We first show that, under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We explore how the introduction of RI can help the model fit the joint equilibrium dynamics of consumption, income, and wealth. We then contrast RI with habit formation and show that the two models make very different general equilibrium predictions, and that RI is closer to the data. We finally show that the equilibrium welfare costs of incomplete information due to RI are relatively low within the CARA-Gaussian setting