Implications of Rational Inattention for Labor Supply and Portfolio Choice

Agents in standard models are assumed to observe the realization of the state with certainty hence implicitly requiring agents to have unlimited information-processing capacity. Sims (2006) argues that the unlimited capacity is a very strong assumption for ordinary people as it implies that they can respond to innovations in economic variables. My research focuses on the impact of information processing capacity (IPC) constraints on agents' decision making. I examine these impacts extending standard models with information processing constraint.;In the first chapter, I analyze labor supply choice under an assumption of information processing constraint by extending a standard 2-period labor supply model. For relatively small information processing capacity, agents behave as if they are highly risk averse and this increases labor supply and reduces consumption in each period. Rational inattention produces a weak correlation between wage and hours in an otherwise standard labor supply model. The degree of intertemporal substitution of labor is different across different IPC. So depending on how capacity-constrained are the agents, an empirical estimation may provide different IES. In particular, the empirical estimations may be biased downward if agents are significantly constrained by IPC. I assess the bias using artificial data generated by the model. Standard econometric analysis provides much lower (75% lower) estimate than the true IES for a relatively small IPC.;The second chapter (co-written with Yulei Luo and Eric Young) analyzes portfolio choice with information processing capacity. A standard portfolio choice model with a reasonable risk-aversion parameter generates a low investment rate in the risky asset for agents with smaller information processing capacity as in the data. As information processing capacity gets smaller the agent becomes highly risk averse and allocates similar consumption level on possible states of the current wealth, which in turn increases precautionary saving. Moreover, the agent becomes extremely tolerant towards the changes in consumption over time for a given risk aversion and the intertemporal elasticity of substitution increases. The simple portfolio choice model with rational inattention provides higher risk aversion and higher intertemporal elasticity (IES) of substitution simultaneously. The model implies that some households will buy no stocks, and some will buy only a small amount, while others invest nearly all their saving in stocks.;The third chapter provides basic ideas of the information theory and rational inattention.