Some Thoughts on Inattention

Maher Said February 3, 2006

Background

The vast majority of important economic decisions are taken infrequently and discontinuously; for example, producers do not update their prices instantaneously when they observe a change in demand or in their cost structure they set prices periodically. Sticky prices and other decisions are a fact of our economic existence. With this in mind, a recent trend within the macroeconomic literature has been to attempt to model this stickiness as the outcome of rational behavior instead of simply assuming that, say, wages are exogenously taken to be sticky. There are two main strands within the current literature on this topic: stickiness due to information acquisition and processing costs, and stickiness due to limited informational capacity.

1.1

Information Acquisition and Processing Costs

Mankiw and Reis (2002) propose a replacement to the New Keynesian Phillips Curve that is based on a somewhat ad hoc sticky information model. They assume that in each period, a fraction of rms obtain new information about the state of the economy and computes a new path of optimal prices; meanwhile, the remaining rms continue to set prices based on old plans and outdated information. Using this basic framework, they derive several results concerning the link between ination and output that seem to match observed empirical regularities rather well. The microfoundations for such a model are developed in Reis (2004) and (2006). Here, the author assumes that agents are fully rational and make optimal choices; however, the agent incurs a cost whenever she acquires information and makes optimal decisions. This cost is interpreted as the cost of obtaining information, processing and interpreting it, and then deciding how to optimally update their plans. Facing these costs, a person setting a plan of action for consumption, for example, must choose not only what to consume, but also when to again incur costs of learning about the state of the economy and to readjust their consumption plan. This process then leads to optimal inattentiveness the agent balances the tradeos between making potentially sub-optimal choices for some length of time and the costs of ensuring that future choices are optimal.

1.2

Limited Informational Capacity

The second recent strand of literature is due in large part to Sims (1998) and (2003), where he argues for modeling the inertia of economic agents as the outcome of informational capacity constraints. In particular, he assumes that agents payos are dependent upon a number of stochastic state variables; however, agents have only limited capacity to observe these variables. This limited capacity is modeled by Shannon capacity, a measure of information ow that uses the reduction in the entropy of a probability distribution. Mackowiak and Wiederholt (2005) build a model of rm behavior that is based upon Sims ideas rms optimally decide what to observe, choosing the number of signals that they receive each period as well as the stochastic properties of these signals. However, rms face the constraint that the information ow between the sequence of signals and the sequence of states of the economy are bounded. In particular, this implies that rms may decide which state variables to observe with greater precision, and which variables to observe with lesser precision. This model seems to be rather successful in explaining observed price-setting behavior by rms.

Possible Directions for Future Work

Where can we go from here? It is interesting that Sims (2003) praises Keynes original stickiness idea because it is inconsistent with the assumption of continuously optimizing agents interacting in continuously clearing markets. He, along with Mankiw, Reis, Mackowiak, and Wiederholt, seem to be interested in heading towards models of somewhat bounded rationality, where agents do not have perfect information and face cognitive constraints. However, in terms of modeling the behavior of these agents, these authors build in what could be interpreted as extra layers of rationality agents no longer solve one optimal control problem; instead, they solve an entire family of such problems, and then choose the maximal solution among these optima. Thus, in Reis models, agents must solve for the optimal consumption path given a set of periods in which state variables may be observed. Then, they must optimize over the set of all possible observation periods. Similarly, Mackowiak and Wiederholts rms solve for the optimal pricing paths given an informational structure, and then solve a constrained optimization problem in selecting the optimal information acquisition mechanism. Frankly, these methods seem to miss the point. One alternative approach that could combine limited information acquisition or processing ability with more boundedly rational behavior would be to introduce a reinforcement learning rule-of-thumb type procedure. For example, consider an innitely-lived consumer in a stochastic environment one in which future income and interest rates are unknown. We may further assume that the consumer does not know the distributions governing these two stochastic processes. However, in each period, the consumer can choose the relative precision with which to observe signals of the next realization of the variables they can reduce the variance of one observation or the other. Given this choice, the consumer then chooses a level of consumption and receives a benet according to some instantaneous utility function. The innovation here would be allowing the re2

alized utility to act as the payo from one play on a 2-armed bandit; the consumer will learn whether it is more benecial to observe future income or to observe future interest rates, and adjust their choices accordingly. Such a process can then act in place of the second level of optimization found in the rational inattention literature, serving as an alternative (less rational) rationalization for inattentiveness to economic variables.

References
[1] Ma ckowiak, Bartosz and Mirko Wiederholt (2005). Optimal Sticky Prices Under Rational Inattention. Mimeo, Humboldt University Berlin. [2] Mankiw, N. Gregory and Ricardo Reis (2002). Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve. Quarterly Journal of Economics 117: 1295-1328. [3] Reis, Ricardo (2004). Inattentive Consumers. Mimeo, Princeton University. [4] Reis, Ricardo (2006). Inattentive Producers. Review of Economic Studies, forthcoming. [5] Sims, Christopher (1998). Stickiness. Carnegie-Rochester Conference Series on Public Policy 49: 317-356. [6] Sims, Christopher (2003). Implications of Rational Inattention. Journal of Monetary Economics 50: 665-690. [7] Sims, Christopher (2006). Rational Inattention: A Research Agenda. American Economic Review, forthcoming.