Rational inattention is an imperfect information mechanism that captures the fact that people are constrained in their ability to process information, and asserts that the imperfect ability to process information is the ultimate reason for imperfect learning. It features the optimal allocation of the scarce attention resource and the endogenous nature of information. My research focuses on the theoretical implications and empirical relevance of rational inattention for price dynamics in an environment with volatility uncertainty, and the implications on monetary policy.
The first chapter, "Rational Inattention in Uncertain Business Cycles," explores the impact of uncertainty shocks on price dynamics when there are information frictions resulting from limited information processing capability. The model shows that changes in shock volatility translate into changes in firms' response in levels through the endogenous role of information. Firms optimally adjust their information choice when a volatility shock occurs, and their pricing behavior changes accordingly. The paper proposes endogenous information choice as another channel through which volatility uncertainty affects economic activity. According to the model, 1) firms' learning and optimal attention exhibits inertia and asymmetry in response to volatility changes; 2) firms choose to process more information when uncertainty increases, especially about aggregate conditions; 3) responses to shocks are more sensitive as firms rationally choose to increase their information processing capability when perceived volatility increases. The paper sheds light on such issues as why monetary policy has time-dependent effects, whether and when to make policy changes and public announcements, and why economic agents' sentiments, the so-called "animal spirits," have real effects.
The chapter also provides empirical support for my model by using regime-dependent factor-augmented vector autoregression (FAVAR) analysis. I use FAVAR to decompose the fluctuations of sectoral price series into aggregate and sector-specific components, and explore their statistical properties and dynamics under different economic regimes. The results suggest: 1) sectoral prices exhibit higher aggregate volatility and lower persistence during recessions than during expansions; 2) sectoral price responses to aggregate shocks are more front-loaded during recessions; 3) there is a significant positive correlation between volatility and responsiveness to macro and micro level shocks, which suggests that attentiveness and responsiveness are positively related as predicted by the theoretical model. The results are robust to alternative economic regime indicators and multiple responsiveness measures.
The second chapter "Monetary Policy for Rational Inattentive Economies with Staggered Price Setting," examines the optimal monetary policy when firms are constrained by their information processing capability for frequent price adjustments. Firms' optimal information processing follows the rational inattention framework as in Sims (2003), which features an endogenous nature of information learning and contingency on the economic regime. Staggered price setting introduces the observed price stickiness and additional policy tradeoffs. The integrated model implies an optimal policy that commits to complete price stabilization in response to natural rate shocks but not in response to markup shocks. In the presence of markup shocks, the central bank faces tradeoffs among conflicting goals caused by information dispersion and nominal frictions.