Consumption Dynamics , Asset Pricing , and Welfare E ff ects under Information Processing Constraints ∗

This paper studies consumption and savings dynamics, asset returns, and welfare losses in three macroeconomic models with information processing constraints which is also called “rational inattention” (henceforth, RI) in Sims (2003). The first model is a standard Linear Quadratic Gaussian (henceforth, LQG) permanent income (henceforth, PIH) model. We show that incorporating RI can better explain the data and find that (1) the gradual responses of consumption to various shocks to wealth, (2) the excess sensitivity of consumption to lagged shocks, and (3) the excess smoothness of aggregate consumption. We then derive optimal channel capacity that depends on the model structure parameters, and calculate the welfare losses due to RI. Furthermore, we compare the RI model with other PIH models with frictions. In the second model, we solve a consumption capital asset pricing model (henceforth, CCAPM) with RI and find that RI can simultaneously explain the smoothness of consumption, the low contemporaneous covariance between consumption growth and asset returns, and the high equity risk premium measured by the ultimate consumption risk. The third one is a risk-sensitive LQG PIH model, in which the risksensitive preference combined with labor income uncertainty generates precautionary savings motive. We then examine the effects of RI on both precautionary savings and the marginal propensity to consume out of income and wealth, as well as the interactions among risk aversion, income uncertainty, and RI.